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Objective of CF PDF
Objective of CF PDF
Damodaran 0
CORPORATE
FINANCE
B40.2302
LECTURE
NOTES:
PACKET
1
Aswath
Damodaran
Aswath
Damodaran
1
The hurdle rate The return How much How you choose
should reflect the The optimal The right kind
should reflect the cash you can to return cash to
riskiness of the mix of debt of debt
magnitude and return the owners will
investment and and equity matches the
the timing of the depends upon depend on
the mix of debt maximizes firm tenor of your
cashflows as welll current & whether they
and equity used value assets
as all side effects. potential prefer dividends
to fund it. investment or buybacks
opportunities
Aswath
Damodaran
2
The
ObjecUve
in
Decision
Making
3
¨ In
tradiUonal
corporate
finance,
the
objecUve
in
decision
making
is
to
maximize
the
value
of
the
firm.
¨ A
narrower
objecUve
is
to
maximize
stockholder
wealth.
When
the
stock
is
traded
and
markets
are
viewed
to
be
efficient,
the
objecUve
is
to
maximize
the
stock
price.
Maximize equity Maximize market
Maximize value estimate of equity
firm value
value
Assets Liabilities
Existing Investments Fixed Claim on cash flows
Generate cashflows today Assets in Place Debt Little or No role in management
Includes long lived (fixed) and Fixed Maturity
short-lived(working Tax Deductible
capital) assets
Expected Value that will be Growth Assets Equity Residual Claim on cash flows
created by future investments Significant Role in management
Perpetual Lives
Aswath
Damodaran
3
Maximizing
Stock
Prices
is
too
“narrow”
an
objecUve:
A
preliminary
response
4
Aswath
Damodaran
5
The
Classical
ObjecUve
FuncUon
6
STOCKHOLDERS
FINANCIAL MARKETS
Aswath
Damodaran
6
What
can
go
wrong?
7
STOCKHOLDERS
FINANCIAL MARKETS
Aswath
Damodaran
7
I.
Stockholder
Interests
vs.
Management
Interests
8
Aswath
Damodaran
8
The
Annual
MeeUng
as
a
disciplinary
venue
9
¨ The
power
of
stockholders
to
act
at
annual
meeUngs
is
diluted
by
three
factors
¤ Most
small
stockholders
do
not
go
to
meeUngs
because
the
cost
of
going
to
the
meeUng
exceeds
the
value
of
their
holdings.
¤ Incumbent
management
starts
off
with
a
clear
advantage
when
it
comes
to
the
exercise
of
proxies.
Proxies
that
are
not
voted
becomes
votes
for
incumbent
management.
¤ For
large
stockholders,
the
path
of
least
resistance,
when
confronted
by
managers
that
they
do
not
like,
is
to
vote
with
their
feet.
¨ Annual
meeUngs
are
also
Ughtly
scripted
and
controlled
events,
making
it
difficult
for
outsiders
and
rebels
to
bring
up
issues
that
are
not
to
the
management’s
liking.
Aswath
Damodaran
9
And
insUtuUonal
investors
go
along
with
incumbent
managers…
10
Aswath
Damodaran
10
Board
of
Directors
as
a
disciplinary
mechanism
11
¨ Directors
are
paid
well:
In
2010,
the
median
board
member
at
a
Fortune
500
company
was
paid
$212,512,
with
54%
coming
in
stock
and
the
remaining
46%
in
cash.
If
a
board
member
was
a
non-‐execuUve
chair,
he
or
she
received
about
$150,000
more
in
compensaUon.
¨ Spend
more
Ume
on
it
than
they
used
to:
A
board
member
worked,
on
average,
about
227.5
hours
a
year
(and
that
is
being
generous),
or
4.4
hours
a
week,
according
to
the
NaUonal
Associate
of
Corporate
Directors.
Of
this,
about
24
hours
a
year
are
for
board
meeUngs.
Those
numbers
are
up
from
what
they
were
a
decade
ago.
¨ Even
those
hours
are
not
very
producUve:
While
the
Ume
spent
on
being
a
director
has
gone
up,
a
significant
porUon
of
that
Ume
was
spent
on
making
sure
that
they
are
legally
protected
(regulaUons
&
lawsuits).
¨ And
they
have
many
loyalUes:
Many
directors
serve
on
three
or
more
boards,
and
some
are
full
Ume
chief
execuUves
of
other
companies.
Aswath
Damodaran
11
The
CEO
o^en
hand-‐picks
directors..
12
¨ CEOs
pick
directors:
A
1992
survey
by
Korn/Ferry
revealed
that
74%
of
companies
relied
on
recommendaUons
from
the
CEO
to
come
up
with
new
directors
and
only
16%
used
an
outside
search
firm.
While
that
number
has
changed
in
recent
years,
CEOs
sUll
determine
who
sits
on
their
boards.
While
more
companies
have
outsiders
involved
in
picking
directors
now,
CEOs
exercise
significant
influence
over
the
process.
¨ Directors
don’t
have
big
equity
stakes:
Directors
o^en
hold
only
token
stakes
in
their
companies.
Most
directors
in
companies
today
sUll
receive
more
compensaUon
as
directors
than
they
gain
from
their
stockholdings.
While
share
ownership
is
up
among
directors
today,
they
usually
get
these
shares
from
the
firm
(rather
than
buy
them).
¨ And
some
directors
are
CEOs
of
other
firms:
Many
directors
are
themselves
CEOs
of
other
firms.
Worse
sUll,
there
are
cases
where
CEOs
sit
on
each
other’s
boards.
Aswath
Damodaran
12
Directors
lack
the
experUse
(and
the
willingness)
to
ask
the
necessary
tough
quesUons..
13
¨ Robert’s
Rules
of
Order?
In
most
boards,
the
CEO
conUnues
to
be
the
chair.
Not
surprisingly,
the
CEO
sets
the
agenda,
chairs
the
meeUng
and
controls
the
informaUon
provided
to
directors.
¨ Be
a
team
player?
The
search
for
consensus
overwhelms
any
aOempts
at
confrontaUon.
¨ The
CEO
as
authority
figure:
Studies
of
social
psychology
have
noted
that
loyalty
is
hardwired
into
human
behavior.
While
this
loyalty
is
an
important
tool
in
building
up
organizaUons,
it
can
also
lead
people
to
suppress
internal
ethical
standards
if
they
conflict
with
loyalty
to
an
authority
figure.
In
a
board
meeUng,
the
CEO
generally
becomes
the
authority
figure.
Aswath
Damodaran
13
The
worst
board
ever?
The
Disney
Experience
-‐
1997
14
Aswath
Damodaran
14
The
Calpers
Tests
for
Independent
Boards
15
¤ Is
the
chairman
of
the
board
independent
of
the
company
(and
not
the
CEO
of
the
company)?
¤ Are
the
compensaUon
and
audit
commiOees
composed
enUrely
of
outsiders?
¨ Disney
was
the
only
S&P
500
company
to
fail
all
three
tests.
Aswath
Damodaran
15
Business
Week
piles
on…
The
Worst
Boards
in
1997..
16
Aswath
Damodaran
16
ApplicaUon
Test:
Who’s
on
board?
17
¨ Look
at
the
board
of
directors
for
your
firm.
¤ How
many
of
the
directors
are
inside
directors
(Employees
of
the
firm,
ex-‐managers)?
¤ Is
there
any
informaUon
on
how
independent
the
directors
in
the
firm
are
from
the
managers?
¨ Are
there
any
external
measures
of
the
quality
of
corporate
governance
of
your
firm?
¤ Yahoo!
Finance
now
reports
on
a
corporate
governance
score
for
firms,
where
it
ranks
firms
against
the
rest
of
the
market
and
against
their
sectors.
¨ Is
there
tangible
evidence
that
your
board
acts
independently
of
management?
¤ Check
news
stories
to
see
if
there
are
acUons
that
the
CEO
has
wanted
to
take
that
the
board
has
stopped
him
or
her
from
taking
or
at
least
slowed
him
or
her
down.
Aswath
Damodaran
17
So,
what
next?
When
the
cat
is
idle,
the
mice
will
play
....
18
¨ When
managers
do
not
fear
stockholders,
they
will
o^en
put
their
interests
over
stockholder
interests
No stockholder approval needed….. Stockholder Approval needed
¤ Greenmail:
The
(managers
of
)
target
of
a
hosUle
takeover
buy
out
the
potenUal
acquirer's
exisUng
stake,
at
a
price
much
greater
than
the
price
paid
by
the
raider,
in
return
for
the
signing
of
a
'standsUll'
agreement.
¤ Golden
Parachutes:
Provisions
in
employment
contracts,
that
allows
for
the
payment
of
a
lump-‐sum
or
cash
flows
over
a
period,
if
managers
covered
by
these
contracts
lose
their
jobs
in
a
takeover.
¤ Poison
Pills:
A
security,
the
rights
or
cashflows
on
which
are
triggered
by
an
outside
event,
generally
a
hosUle
takeover,
is
called
a
poison
pill.
¤ Shark
Repellents:
AnU-‐takeover
amendments
are
also
aimed
at
dissuading
hosUle
takeovers,
but
differ
on
one
very
important
count.
They
require
the
assent
of
stockholders
to
be
insUtuted.
¤ Overpaying
on
takeovers:
AcquisiUons
o^en
are
driven
by
management
interests
rather
than
stockholder
interests.
Aswath
Damodaran
18
Overpaying
on
takeovers
19
¨ The
quickest
and
perhaps
the
most
decisive
way
to
impoverish
stockholders
is
to
overpay
on
a
takeover.
¨ The
stockholders
in
acquiring
firms
do
not
seem
to
share
the
enthusiasm
of
the
managers
in
these
firms.
Stock
prices
of
bidding
firms
decline
on
the
takeover
announcements
a
significant
proporUon
of
the
Ume.
¨ Many
mergers
do
not
work,
as
evidenced
by
a
number
of
measures.
¤ The
profitability
of
merged
firms
relaUve
to
their
peer
groups,
does
not
increase
significantly
a^er
mergers.
¤ An
even
more
damning
indictment
is
that
a
large
number
of
mergers
are
reversed
within
a
few
years,
which
is
a
clear
admission
that
the
acquisiUons
did
not
work.
Aswath
Damodaran
19
A
case
study
in
value
destrucUon:
Eastman
Kodak
&
Sterling
Drugs
5,000
4,500
4,000
3,500
3,000
2,500
2,000
1,500
1,000
500
0
1988 1989 1990 1991 1992
Aswath
Damodaran
21
Kodak
Says
Drug
Unit
Is
Not
for
Sale
…
but…
22
¨ An
arUcle
in
the
NY
Times
in
August
of
1993
suggested
that
Kodak
was
eager
to
shed
its
drug
unit.
¤ In
response,
Eastman
Kodak
officials
say
they
have
no
plans
to
sell
Kodak’s
Sterling
Winthrop
drug
unit.
¤ Louis
Mass,
Chairman
of
Sterling
Winthrop,
dismissed
the
rumors
as
“massive
speculaUon,
which
flies
in
the
face
of
the
stated
intent
of
Kodak
that
it
is
commiOed
to
be
in
the
health
business.”
¨ A
few
months
later…Taking
a
stride
out
of
the
drug
business,
Eastman
Kodak
said
that
the
Sanofi
Group,
a
French
pharmaceuUcal
company,
agreed
to
buy
the
prescripUon
drug
business
of
Sterling
Winthrop
for
$1.68
billion.
¤ Shares
of
Eastman
Kodak
rose
75
cents
yesterday,
closing
at
$47.50
on
the
New
York
Stock
Exchange.
¤ Samuel
D.
Isaly
an
analyst
,
said
the
announcement
was
“very
good
for
Sanofi
and
very
good
for
Kodak.”
¤
“When
the
divesUtures
are
complete,
Kodak
will
be
enUrely
focused
on
imaging,”
said
George
M.
C.
Fisher,
the
company's
chief
execuUve.
¤ The
rest
of
the
Sterling
Winthrop
was
sold
to
Smithkline
for
$2.9
billion.
Aswath
Damodaran
22
The
connecUon
to
corporate
governance:
HP
buys
Autonomy…
and
explains
the
premium
23
Aswath
Damodaran
23
A
year
later…
HP
admits
a
mistake…and
explains
it…
24
Aswath
Damodaran
24
ApplicaUon
Test:
Who
owns/runs
your
firm?
25
Employees Lenders
Inside stockholders
% of stock held
Voting and non-voting shares
Control structure
Aswath
Damodaran
25
Case
1:
Splintering
of
Stockholders
Disney’s
top
stockholders
in
2003
Aswath Damodaran
26
Case
2:
VoUng
versus
Non-‐voUng
Shares
&
Golden
Shares:
Vale
Aswath Damodaran
28
Case
4:
Legal
rights
and
Corporate
Structures:
Baidu
¨ The
Board:
The
company
has
six
directors,
one
of
whom
is
Robin
Li,
who
is
the
founder/CEO
of
Baidu.
Mr.
Li
also
owns
a
majority
stake
of
Class
B
shares,
which
have
ten
Umes
the
voUng
rights
of
Class
A
shares,
granUng
him
effecUve
control
of
the
company.
¨ The
structure:
Baidu
is
a
Chinese
company,
but
it
is
incorporated
in
the
Cayman
Islands,
its
primary
stock
lisUng
is
on
the
NASDAQ
and
the
listed
company
is
structured
as
a
shell
company,
to
get
around
Chinese
government
restricUons
of
foreign
investors
holding
shares
in
Chinese
corporaUons.
¨ The
legal
system:
Baidu’s
operaUng
counterpart
in
China
is
structured
as
a
Variable
Interest
EnUty
(VIE),
and
it
is
unclear
how
much
legal
power
the
shareholders
in
the
shell
company
have
to
enforce
changes
at
the
VIE.
Aswath Damodaran
29
Things
change..
Disney’s
top
stockholders
in
2009
30
Aswath
Damodaran
30
II.
Stockholders'
objecUves
vs.
Bondholders'
objecUves
31
Aswath
Damodaran
31
Examples
of
the
conflict..
32
Aswath
Damodaran
32
An
Extreme
Example:
Unprotected
Lenders?
33
Aswath
Damodaran
33
III.
Firms
and
Financial
Markets
34
Aswath
Damodaran
34
Managers
control
the
release
of
informaUon
to
the
general
public
35
8.00%
6.00%
4.00%
2.00%
0.00%
-2.00%
-4.00%
-6.00%
Monday Tuesday Wednesday Thursday Friday
% Chg(EPS) % Chg(DPS)
Aswath
Damodaran
36
Some
criUques
of
market
efficiency..
37
¨ Focusing
on
market
prices
will
lead
companies
towards
short
term
decisions
at
the
expense
of
long
term
value.
a.
I
agree
with
the
statement
b.
I
do
not
agree
with
this
statement
¨ Allowing
managers
to
make
decisions
without
having
to
worry
about
the
effect
on
market
prices
will
lead
to
beOer
long
term
decisions.
a. I
agree
with
this
statement
b. I
do
not
agree
with
this
statement
¨ Neither
managers
nor
markets
are
trustworthy.
RegulaUons/
laws
should
be
wriOen
that
force
firms
to
make
long
term
decisions.
a. I
agree
with
this
statement
b. I
do
not
agree
with
this
statement
Aswath
Damodaran
38
Are
markets
short
term?
Some
evidence
that
they
are
not..
39
¨ Value
of
young
firms:
There
are
hundreds
of
start-‐up
and
small
firms,
with
no
earnings
expected
in
the
near
future,
that
raise
money
on
financial
markets.
Why
would
a
myopic
market
that
cares
only
about
short
term
earnings
aOach
high
prices
to
these
firms?
¨ Current
earnings
vs
Future
growth:
If
the
evidence
suggests
anything,
it
is
that
markets
do
not
value
current
earnings
and
cashflows
enough
and
value
future
earnings
and
cashflows
too
much.
A^er
all,
studies
suggest
that
low
PE
stocks
are
under
priced
relaUve
to
high
PE
stocks
¨ Market
reacUon
to
investments:
The
market
response
to
research
and
development
and
investment
expenditures
is
generally
posiUve.
Aswath
Damodaran
39
If
markets
are
so
short
term,
why
do
they
react
to
big
investments
(that
potenUally
lower
short
term
earnings)
so
posiUvely?
40
Aswath
Damodaran
40
But
what
about
market
crises?
41
¨ Markets
are
the
problem:
Many
criUcs
of
markets
point
to
market
bubbles
and
crises
as
evidence
that
markets
do
not
work.
For
instance,
the
market
turmoil
between
September
and
December
2008
is
pointed
to
as
backing
for
the
statement
that
free
markets
are
the
source
of
the
problem
and
not
the
soluUon.
¨ The
counter:
There
are
two
counter
arguments
that
can
be
offered:
¤ The
events
of
the
last
quarter
of
2008
illustrate
that
we
are
more
dependent
on
funcUoning,
liquid
markets,
with
risk
taking
investors,
than
ever
before
in
history.
As
we
saw,
no
government
or
other
enUty
(bank,
BuffeO)
is
big
enough
to
step
in
and
save
the
day.
¤ The
firms
that
caused
the
market
collapse
(banks,
investment
banks)
were
among
the
most
regulated
businesses
in
the
market
place.
If
anything,
their
failures
can
be
traced
to
their
aOempts
to
take
advantage
of
regulatory
loopholes
(badly
designed
insurance
programs…
capital
measurements
that
miss
risky
assets,
especially
derivaUves)
Aswath
Damodaran
41
IV.
Firms
and
Society
42
Aswath
Damodaran
42
Social
Costs
and
Benefits
are
difficult
to
quanUfy
because
..
43
¨ Cannot
know
the
unknown:
They
might
not
be
known
at
the
Ume
of
the
decision.
In
other
words,
a
firm
may
think
that
it
is
delivering
a
product
that
enhances
society,
at
the
Ume
it
delivers
the
product
but
discover
a^erwards
that
there
are
very
large
costs.
(Asbestos
was
a
wonderful
product,
when
it
was
devised,
light
and
easy
to
work
with…
It
is
only
a^er
decades
that
the
health
consequences
came
to
light)
¨ Eyes
of
the
beholder:
They
are
‘person-‐specific’,
since
different
decision
makers
can
look
at
the
same
social
cost
and
weight
them
very
differently.
¨ Decision
paralysis:
They
can
be
paralyzing
if
carried
to
extremes.
Aswath
Damodaran
43
A
test
of
your
social
consciousness:
Put
your
money
where
you
mouth
is…
44
¨ Assume
that
you
work
for
Disney
and
that
you
have
an
opportunity
to
open
a
store
in
an
inner-‐city
neighborhood.
The
store
is
expected
to
lose
about
a
million
dollars
a
year,
but
it
will
create
much-‐needed
employment
in
the
area,
and
may
help
revitalize
it.
¨ Would
you
open
the
store?
¤ Yes
¤ No
¨ If
yes,
would
you
tell
your
stockholders
and
let
them
vote
on
the
issue?
¤ Yes
¤ No
¨ If
no,
how
would
you
respond
to
a
stockholder
query
on
why
you
were
not
living
up
to
your
social
responsibiliUes?
Aswath
Damodaran
44
So
this
is
what
can
go
wrong...
45
STOCKHOLDERS
Managers put
Have little control their interests
over managers above stockholders
FINANCIAL MARKETS
Aswath
Damodaran
45
TradiUonal
corporate
financial
theory
breaks
down
when
...
46
Aswath
Damodaran
46
When
tradiUonal
corporate
financial
theory
breaks
down,
the
soluUon
is:
47
Aswath
Damodaran
47
I.
An
AlternaUve
Corporate
Governance
System
48
Aswath
Damodaran
48
II.
Choose
a
Different
ObjecUve
FuncUon
49
¨ The
key
thing
to
remember
is
that
these
are
intermediate
objecUve
funcUons.
¤ To
the
degree
that
they
are
correlated
with
the
long
term
health
and
value
of
the
company,
they
work
well.
¤ To
the
degree
that
they
do
not,
the
firm
can
end
up
with
a
disaster
Aswath
Damodaran
49
III.
Maximize
Stock
Price,
subject
to
..
50
Aswath
Damodaran
50
The
Stockholder
Backlash
51
Aswath
Damodaran
51
The
HosUle
AcquisiUon
Threat
52
¨ Boards
have
become
smaller
over
Ume.
The
median
size
of
a
board
of
directors
has
decreased
from
16
to
20
in
the
1970s
to
between
9
and
11
in
1998.
The
smaller
boards
are
less
unwieldy
and
more
effecUve
than
the
larger
boards.
¨ There
are
fewer
insiders
on
the
board.
In
contrast
to
the
6
or
more
insiders
that
many
boards
had
in
the
1970s,
only
two
directors
in
most
boards
in
1998
were
insiders.
¨ Directors
are
increasingly
compensated
with
stock
and
opUons
in
the
company,
instead
of
cash.
In
1973,
only
4%
of
directors
received
compensaUon
in
the
form
of
stock
or
opUons,
whereas
78%
did
so
in
1998.
¨ More
directors
are
idenUfied
and
selected
by
a
nominaUng
commiOee
rather
than
being
chosen
by
the
CEO
of
the
firm.
In
1998,
75%
of
boards
had
nominaUng
commiOees;
the
comparable
staUsUc
in
1973
was
2%.
Aswath
Damodaran
53
Disney:
Eisner’s
rise
&
fall
from
grace
¨ In
his
early
years
at
Disney,
Michael
Eisner
brought
about
long-‐delayed
changes
in
the
company
and
put
it
on
the
path
to
being
an
entertainment
giant
that
it
is
today.
His
success
allowed
him
to
consolidate
power
and
the
boards
that
he
created
were
increasingly
capUve
ones
(see
the
1997
board).
¨ In
1996,
Eisner
spearheaded
the
push
to
buy
ABC
and
the
board
rubberstamped
his
decision,
as
they
had
with
other
major
decisions.
In
the
years
following,
the
company
ran
into
problems
both
on
its
ABC
acquisiUon
and
on
its
other
operaUons
and
stockholders
started
to
get
resUve,
especially
as
the
stock
price
halved
between
1998
and
2002.
¨ In
2003,
Roy
Disney
and
Stanley
Gold
resigned
from
the
Disney
board,
arguing
against
Eisner’s
autocraUc
style.
¨ In
early
2004,
Comcast
made
a
hosUle
bid
for
Disney
and
later
in
the
year,
43%
of
Disney
shareholders
withheld
their
votes
for
Eisner’s
reelecUon
to
the
board
of
directors.
Following
that
vote,
the
board
of
directors
at
Disney
voted
unanimously
to
elect
George
Mitchell
as
the
Chair
of
the
board,
replacing
Eisner,
who
vowed
to
stay
on
as
CEO.
Aswath Damodaran
54
Eisner’s
concession:
Disney’s
Board
in
2003
55
Aswath
Damodaran
55
Changes
in
corporate
governance
at
Disney
56
1. Required
at
least
two
execuUve
sessions
of
the
board,
without
the
CEO
or
other
members
of
management
present,
each
year.
2. Created
the
posiUon
of
non-‐management
presiding
director,
and
appointed
Senator
George
Mitchell
to
lead
those
execuUve
sessions
and
assist
in
sesng
the
work
agenda
of
the
board.
3. Adopted
a
new
and
more
rigorous
definiUon
of
director
independence.
4. Required
that
a
substanUal
majority
of
the
board
be
comprised
of
directors
meeUng
the
new
independence
standards.
5. Provided
for
a
reducUon
in
commiOee
size
and
the
rotaUon
of
commiOee
and
chairmanship
assignments
among
independent
directors.
6. Added
new
provisions
for
management
succession
planning
and
evaluaUons
of
both
management
and
board
performance
7. Provided
for
enhanced
conUnuing
educaUon
and
training
for
board
members.
Aswath
Damodaran
56
Eisner’s
exit…
and
a
new
age
dawns?
Disney’s
board
in
2008
57
Aswath
Damodaran
57
But
as
a
CEO’s
tenure
lengthens,
does
corporate
governance
suffer?
1. While
the
board
size
has
stayed
compact
(at
twelve
members),
there
has
been
only
one
change
since
2008,
with
Sheryl
Sandberg,
COO
of
Facebook,
replacing
the
deceased
Steve
Jobs.
2. The
board
voted
reinstate
Iger
as
chair
of
the
board
in
2011,
reversing
a
decision
made
to
separate
the
CEO
and
Chair
posiUons
a^er
the
Eisner
years.
3. In
2011,
Iger
announced
his
intent
to
step
down
as
CEO
in
2015
but
Disney’s
board
convinced
Iger
to
stay
on
as
CEO
for
an
extra
year,
for
the
“the
good
of
the
company”.
4. There
were
signs
of
resUveness
among
Disney’s
stockholders,
especially
those
interested
in
corporate
governance.
AcUvist
investors
(CalSTRS)
starUng
making
noise
and
InsUtuUonal
Shareholder
Services
(ISS),
which
gauges
corporate
governance
at
companies,
raised
red
flags
about
compensaUon
and
board
monitoring
at
Disney.
Aswath Damodaran
58
What
about
legislaUon?
59
¤ The
costs
of
meeUng
legal
requirements
o^en
exceed
the
benefits
¤ Laws
always
have
unintended
consequences
Aswath
Damodaran
59
Is
there
a
payoff
to
beOer
corporate
governance?
60
¨ In
the
most
comprehensive
study
of
the
effect
of
corporate
governance
on
value,
a
governance
index
was
created
for
each
of
1500
firms
based
upon
24
disUnct
corporate
governance
provisions.
¤ Buying
stocks
that
had
the
strongest
investor
protecUons
while
simultaneously
selling
shares
with
the
weakest
protecUons
generated
an
annual
excess
return
of
8.5%.
¤ Every
one
point
increase
in
the
index
towards
fewer
investor
protecUons
decreased
market
value
by
8.9%
in
1999
¤ Firms
that
scored
high
in
investor
protecUons
also
had
higher
profits,
higher
sales
growth
and
made
fewer
acquisiUons.
¨ The
link
between
the
composiUon
of
the
board
of
directors
and
firm
value
is
weak.
Smaller
boards
do
tend
to
be
more
effecUve.
¨ On
a
purely
anecdotal
basis,
a
common
theme
at
problem
companies
and
is
an
ineffecUve
board
that
fails
to
ask
tough
quesUons
of
an
imperial
CEO.
Aswath
Damodaran
60
The
Bondholders’
Defense
Against
Stockholder
Excesses
61
Aswath
Damodaran
61
The
Financial
Market
Response
62
¨ While
analysts
are
more
likely
sUll
to
issue
buy
rather
than
sell
recommendaUons,
the
payoff
to
uncovering
negaUve
news
about
a
firm
is
large
enough
that
such
news
is
eagerly
sought
and
quickly
revealed
(at
least
to
a
limited
group
of
investors).
¨ As
investor
access
to
informaUon
improves,
it
is
becoming
much
more
difficult
for
firms
to
control
when
and
how
informaUon
gets
out
to
markets.
¨ As
opUon
trading
has
become
more
common,
it
has
become
much
easier
to
trade
on
bad
news.
In
the
process,
it
is
revealed
to
the
rest
of
the
market.
¨ When
firms
mislead
markets,
the
punishment
is
not
only
quick
but
it
is
savage.
Aswath
Damodaran
62
The
Societal
Response
63
Aswath
Damodaran
63
The
Counter
ReacUon
64
STOCKHOLDERS
FINANCIAL MARKETS
Aswath
Damodaran
64
So
what
do
you
think?
65
¨ At
this
point
in
Ume,
the
following
statement
best
describes
where
I
stand
in
terms
of
the
right
objecUve
funcUon
for
decision
making
in
a
business
a. Maximize
stock
price,
with
no
constraints
b. Maximize
stock
price,
with
constraints
on
being
a
good
social
ciUzen.
c. Maximize
stockholder
wealth,
with
good
ciUzen
constraints,
and
hope/pray
that
the
market
catches
up
with
you.
d. Maximize
profits
or
profitability
e. Maximize
earnings
growth
f. Maximize
market
share
g. Maximize
revenues
h. Maximize
social
good
i. None
of
the
above
Aswath
Damodaran
65
The
Modified
ObjecUve
FuncUon
66
The hurdle rate The return How much How you choose
should reflect the The optimal The right kind
should reflect the cash you can to return cash to
riskiness of the mix of debt of debt
magnitude and return the owners will
investment and and equity matches the
the timing of the depends upon depend on
the mix of debt maximizes firm tenor of your
cashflows as welll current & whether they
and equity used value assets
as all side effects. potential prefer dividends
to fund it. investment or buybacks
opportunities
Aswath
Damodaran
68
The
noUon
of
a
benchmark
69
¨ Since
financial
resources
are
finite,
there
is
a
hurdle
that
projects
have
to
cross
before
being
deemed
acceptable.
This
hurdle
should
be
higher
for
riskier
projects
than
for
safer
projects.
¨ A
simple
representaUon
of
the
hurdle
rate
is
as
follows:
Hurdle
rate
=
Riskless
Rate
+
Risk
Premium
¨ The
two
basic
quesUons
that
every
risk
and
return
model
in
finance
tries
to
answer
are:
¤ How
do
you
measure
risk?
¤ How
do
you
translate
this
risk
measure
into
a
risk
premium?
Aswath
Damodaran
69
What
is
Risk?
70
1. It
should
come
up
with
a
measure
of
risk
that
applies
to
all
assets
and
not
be
asset-‐specific.
2. It
should
clearly
delineate
what
types
of
risk
are
rewarded
and
what
are
not,
and
provide
a
raUonale
for
the
delineaUon.
3. It
should
come
up
with
standardized
risk
measures,
i.e.,
an
investor
presented
with
a
risk
measure
for
an
individual
asset
should
be
able
to
draw
conclusions
about
whether
the
asset
is
above-‐average
or
below-‐average
risk.
4. It
should
translate
the
measure
of
risk
into
a
rate
of
return
that
the
investor
should
demand
as
compensaUon
for
bearing
the
risk.
5. It
should
work
well
not
only
at
explaining
past
returns,
but
also
in
predicUng
future
expected
returns.
Aswath
Damodaran
71
The
Capital
Asset
Pricing
Model
72
Expected Return
Aswath
Damodaran
73
How
risky
is
Disney?
A
look
at
the
past…
74
10.00%
5.00%
0.00%
-‐5.00%
-‐10.00%
-‐15.00%
-‐20.00%
-‐25.00%
Dec-‐08
Feb-‐09
Jun-‐09
Aug-‐09
Dec-‐09
Feb-‐10
Jun-‐10
Aug-‐10
Dec-‐10
Feb-‐11
Jun-‐11
Aug-‐11
Dec-‐11
Feb-‐12
Jun-‐12
Aug-‐12
Dec-‐12
Feb-‐13
Jun-‐13
Aug-‐13
Apr-‐09
Apr-‐10
Apr-‐11
Apr-‐12
Apr-‐13
Oct-‐08
Oct-‐09
Oct-‐10
Oct-‐11
Oct-‐12
Aswath
Damodaran
74
Do
you
live
in
a
mean-‐variance
world?
75
¨ Assume
that
you
had
to
pick
between
two
investments.
They
have
the
same
expected
return
of
15%
and
the
same
standard
deviaUon
of
25%;
however,
investment
A
offers
a
very
small
possibility
that
you
could
quadruple
your
money,
while
investment
B’s
highest
possible
payoff
is
a
60%
return.
Would
you
a. be
indifferent
between
the
two
investments,
since
they
have
the
same
expected
return
and
standard
deviaUon?
b. prefer
investment
A,
because
of
the
possibility
of
a
high
payoff?
b. prefer
investment
B,
because
it
is
safer?
¨ Would
your
answer
change
if
you
were
not
told
that
there
is
a
small
possibility
that
you
could
lose
100%
of
your
money
on
investment
A
but
that
your
worst
case
scenario
with
investment
B
is
-‐50%?
Aswath
Damodaran
75
The
Importance
of
DiversificaUon:
Risk
Types
76
Competition
may be stronger
or weaker than Exchange rate
anticipated and Political
risk
Projects may
do better or Interest rate,
worse than Entire Sector Inflation &
may be affected news about
expected by action economy
Firm-specific Market
Aswath
Damodaran
76
Why
diversificaUon
reduces/eliminates
firm
specific
risk
77
¨ Firm-‐specific
risk
can
be
reduced,
if
not
eliminated,
by
increasing
the
number
of
investments
in
your
por|olio
(i.e.,
by
being
diversified).
Market-‐wide
risk
cannot.
This
can
be
jusUfied
on
either
economic
or
staUsUcal
grounds.
¨ On
economic
grounds,
diversifying
and
holding
a
larger
por|olio
eliminates
firm-‐specific
risk
for
two
reasons-‐
a. Each
investment
is
a
much
smaller
percentage
of
the
por|olio,
muUng
the
effect
(posiUve
or
negaUve)
on
the
overall
por|olio.
b. Firm-‐specific
acUons
can
be
either
posiUve
or
negaUve.
In
a
large
por|olio,
it
is
argued,
these
effects
will
average
out
to
zero.
(For
every
firm,
where
something
bad
happens,
there
will
be
some
other
firm,
where
something
good
happens.)
Aswath
Damodaran
77
The
Role
of
the
Marginal
Investor
78
¨ The
marginal
investor
in
a
firm
is
the
investor
who
is
most
likely
to
be
the
buyer
or
seller
on
the
next
trade
and
to
influence
the
stock
price.
¨ Generally
speaking,
the
marginal
investor
in
a
stock
has
to
own
a
lot
of
stock
and
also
trade
that
stock
on
a
regular
basis.
¨ Since
trading
is
required,
the
largest
investor
may
not
be
the
marginal
investor,
especially
if
he
or
she
is
a
founder/manager
of
the
firm
(Larry
Ellison
at
Oracle,
Mark
Zuckerberg
at
Facebook)
¨ In
all
risk
and
return
models
in
finance,
we
assume
that
the
marginal
investor
is
well
diversified.
Aswath
Damodaran
78
IdenUfying
the
Marginal
Investor
in
your
firm…
79
Aswath
Damodaran
79
Gauging
the
marginal
investor:
Disney
in
2013
Aswath Damodaran
80
Extending
the
assessment
of
the
investor
base
¨ In
all
five
of
the
publicly
traded
companies
that
we
are
looking
at,
insUtuUons
are
big
holders
of
the
company’s
stock.
Aswath Damodaran
81
The
LimiUng
Case:
The
Market
Por|olio
82
¨ The
big
assumpUons
&
the
follow
up:
Assuming
diversificaUon
costs
nothing
(in
terms
of
transacUons
costs),
and
that
all
assets
can
be
traded,
the
limit
of
diversificaUon
is
to
hold
a
por|olio
of
every
single
asset
in
the
economy
(in
proporUon
to
market
value).
This
por|olio
is
called
the
market
por|olio.
¨ The
consequence:
Individual
investors
will
adjust
for
risk,
by
adjusUng
their
allocaUons
to
this
market
por|olio
and
a
riskless
asset
(such
as
a
T-‐Bill):
Preferred
risk
level
Alloca?on
decision
No
risk
100%
in
T-‐Bills
Some
risk
50%
in
T-‐Bills;
50%
in
Market
Por|olio;
A
liOle
more
risk
25%
in
T-‐Bills;
75%
in
Market
Por|olio
Even
more
risk
100%
in
Market
Por|olio
A
risk
hog..
Borrow
money;
Invest
in
market
por|olio
Aswath
Damodaran
82
The
Risk
of
an
Individual
Asset
83
¨ The
essence:
The
risk
of
any
asset
is
the
risk
that
it
adds
to
the
market
por|olio
StaUsUcally,
this
risk
can
be
measured
by
how
much
an
asset
moves
with
the
market
(called
the
covariance)
¨ The
measure:
Beta
is
a
standardized
measure
of
this
covariance,
obtained
by
dividing
the
covariance
of
any
asset
with
the
market
by
the
variance
of
the
market.
It
is
a
measure
of
the
non-‐diversifiable
risk
for
any
asset
can
be
measured
by
the
covariance
of
its
returns
with
returns
on
a
market
index,
which
is
defined
to
be
the
asset's
beta.
¨ The
result:
The
required
return
on
an
investment
will
be
a
linear
funcUon
of
its
beta:
¤ Expected
Return
=
Riskfree
Rate+
Beta
*
(Expected
Return
on
the
Market
Por|olio
-‐
Riskfree
Rate)
Aswath
Damodaran
83
LimitaUons
of
the
CAPM
84
Aswath
Damodaran
85
Why
the
CAPM
persists…
86
Aswath
Damodaran
86
ApplicaUon
Test:
Who
is
the
marginal
investor
in
your
firm?
87
¤ An insider
Aswath
Damodaran
87
Aswath
Damodaran
88
FROM
RISK
&
RETURN
MODELS
TO
HURDLE
RATES:
ESTIMATION
CHALLENGES
“The
price
of
purity
is
purists…”
Anonymous
Inputs
required
to
use
the
CAPM
-‐
89
Aswath
Damodaran
89
The
Riskfree
Rate
and
Time
Horizon
90
¨ On
a
riskfree
asset,
the
actual
return
is
equal
to
the
expected
return.
Therefore,
there
is
no
variance
around
the
expected
return.
¨ For
an
investment
to
be
riskfree,
i.e.,
to
have
an
actual
return
be
equal
to
the
expected
return,
two
condiUons
have
to
be
met
–
¤ There
has
to
be
no
default
risk,
which
generally
implies
that
the
security
has
to
be
issued
by
the
government.
Note,
however,
that
not
all
governments
can
be
viewed
as
default
free.
¤ There
can
be
no
uncertainty
about
reinvestment
rates,
which
implies
that
it
is
a
zero
coupon
security
with
the
same
maturity
as
the
cash
flow
being
analyzed.
Aswath
Damodaran
90
Riskfree
Rate
in
PracUce
91
¨ The
riskfree
rate
is
the
rate
on
a
zero
coupon
government
bond
matching
the
Ume
horizon
of
the
cash
flow
being
analyzed.
¨ TheoreUcally,
this
translates
into
using
different
riskfree
rates
for
each
cash
flow
-‐
the
1
year
zero
coupon
rate
for
the
cash
flow
in
year
1,
the
2-‐year
zero
coupon
rate
for
the
cash
flow
in
year
2
...
¨ PracUcally
speaking,
if
there
is
substanUal
uncertainty
about
expected
cash
flows,
the
present
value
effect
of
using
Ume
varying
riskfree
rates
is
small
enough
that
it
may
not
be
worth
it.
Aswath
Damodaran
91
The
BoOom
Line
on
Riskfree
Rates
¨ Using
a
long
term
government
rate
(even
on
a
coupon
bond)
as
the
riskfree
rate
on
all
of
the
cash
flows
in
a
long
term
analysis
will
yield
a
close
approximaUon
of
the
true
value.
For
short
term
analysis,
it
is
enUrely
appropriate
to
use
a
short
term
government
security
rate
as
the
riskfree
rate.
¨ The
riskfree
rate
that
you
use
in
an
analysis
should
be
in
the
same
currency
that
your
cashflows
are
esUmated
in.
¤ In
other
words,
if
your
cashflows
are
in
U.S.
dollars,
your
riskfree
rate
has
to
be
in
U.S.
dollars
as
well.
¤ If
your
cash
flows
are
in
Euros,
your
riskfree
rate
should
be
a
Euro
riskfree
rate.
¨ The
convenUonal
pracUce
of
esUmaUng
riskfree
rates
is
to
use
the
government
bond
rate,
with
the
government
being
the
one
that
is
in
control
of
issuing
that
currency.
In
November
2013,
for
instance,
the
rate
on
a
ten-‐year
US
treasury
bond
(2.75%)
is
used
as
the
risk
free
rate
in
US
dollars.
Aswath Damodaran
92
What
is
the
Euro
riskfree
rate?
An
exercise
in
November
2013
Rate
on
10-‐year
Euro
Government
Bonds:
November
2013
9.00% 8.30%
8.00%
7.00%
6.42%
5.90%
6.00%
5.00%
3.90%
3.95%
4.00%
3.30%
3.00%
2.35%
2.10%
2.15%
1.75%
2.00%
1.00%
0.00%
Germany
Austria
France
Belgium
Ireland
Italy
Spain
Portugal
Slovenia
Greece
Aswath Damodaran
93
When
the
government
is
default
free:
Risk
free
rates
–
in
November
2013
Aswath Damodaran
94
What
if
there
is
no
default-‐free
enUty?
Risk
free
rates
in
November
2013
¨ Adjust
the
local
currency
government
borrowing
rate
for
default
risk
to
get
a
riskless
local
currency
rate.
¤ In
November
2013,
the
Indian
government
rupee
bond
rate
was
8.82%.
the
local
currency
raUng
from
Moody’s
was
Baa3
and
the
default
spread
for
a
Baa3
rated
country
bond
was
2.25%.
Riskfree
rate
in
Rupees
=
8.82%
-‐
2.25%
=
6.57%
¤ In
November
2013,
the
Chinese
Renmimbi
government
bond
rate
was
4.30%
and
the
local
currency
raUng
was
Aa3,
with
a
default
spread
of
0.8%.
Riskfree
rate
in
Chinese
Renmimbi
=
4.30%
-‐
0.8%
=
3.5%
¨ Do
the
analysis
in
an
alternate
currency,
where
gesng
the
riskfree
rate
is
easier.
With
Vale
in
2013,
we
could
chose
to
do
the
analysis
in
US
dollars
(rather
than
esUmate
a
riskfree
rate
in
R$).
The
riskfree
rate
is
then
the
US
treasury
bond
rate.
¨ Do
your
analysis
in
real
terms,
in
which
case
the
riskfree
rate
has
to
be
a
real
riskfree
rate.
The
inflaUon-‐indexed
treasury
rate
is
a
measure
of
a
real
riskfree
rate.
Aswath Damodaran
95
Three
paths
to
esUmaUng
sovereign
default
spreads
96
Figure
4.2:
Risk
free
rates
in
Currencies
where
Governments
not
Aaa
rated
16.00%
14.00%
12.00%
10.00%
8.00%
Default
Spread
6.00%
Risk
free
rate
4.00%
2.00%
0.00%
Aswath
Damodaran
97
98
0.00%
2.00%
4.00%
6.00%
8.00%
-‐2.00%
10.00%
12.00%
14.00%
Japanese
Yen
Czech
Koruna
Swiss
Franc
Euro
Danish
Krone
Swedish
Krona
Aswath
Damodaran
Taiwanese
$
Hungarian
Forint
Bulgarian
Lev
Kuna
Thai
Baht
BriUsh
Pound
Romanian
Leu
Norwegian
Krone
HK
$
Israeli
Shekel
Polish
Zloty
Canadian
$
Korean
Won
US
$
Singapore
$
Phillipine
Peso
Chinese
Yuan
NZ
$
Chilean
Peso
Risk
free
Rates
in
January
2015
Iceland
Krona
Peruvian
Sol
Mexican
Peso
Colombian
Peso
Indonesian
Rupiah
Indian
Rupee
Turkish
Lira
South
African
Rand
Kenyan
Shilling
Reai
Naira
Russian
Ruble
98
Measurement
of
the
risk
premium
99
¤ increase
with
the
risk
aversion
of
the
investors
in
that
market
¤ increase
with
the
riskiness
of
the
“average”
risk
investment
Aswath
Damodaran
99
What
is
your
risk
premium?
¨ Assume
that
stocks
are
the
only
risky
assets
and
that
you
are
offered
two
investment
opUons:
¤ a
riskless
investment
(say
a
Government
Security),
on
which
you
can
make
3%
¤ a
mutual
fund
of
all
stocks,
on
which
the
returns
are
uncertain
¨ How
much
of
an
expected
return
would
you
demand
to
shi^
your
money
from
the
riskless
asset
to
the
mutual
fund?
a. Less
than
3%
b. Between
3%
-‐
5%
c. Between
5%
-‐
7%
d. Between
7%
-‐9%
e. Between
9%-‐
11%
f. More
than
11%
Aswath Damodaran
100
Risk
Aversion
and
Risk
Premiums
101
Aswath
Damodaran
101
Risk
Premiums
do
change..
102
Aswath
Damodaran
102
EsUmaUng
Risk
Premiums
in
PracUce
103
Aswath
Damodaran
103
The
Survey
Approach
104
Aswath
Damodaran
104
The
Historical
Premium
Approach
105
¨ This
is
the
default
approach
used
by
most
to
arrive
at
the
premium
to
use
in
the
model
¨ In
most
cases,
this
approach
does
the
following
¤ Defines
a
Ume
period
for
the
esUmaUon
(1928-‐Present,
last
50
years...)
¤ Calculates
average
returns
on
a
stock
index
during
the
period
¤ Calculates
average
returns
on
a
riskless
security
over
the
period
¤ Calculates
the
difference
between
the
two
averages
and
uses
it
as
a
premium
looking
forward.
¨ The
limitaUons
of
this
approach
are:
¤ it
assumes
that
the
risk
aversion
of
investors
has
not
changed
in
a
systemaUc
way
across
Ume.
(The
risk
aversion
may
change
from
year
to
year,
but
it
reverts
back
to
historical
averages)
¤ it
assumes
that
the
riskiness
of
the
“risky”
por|olio
(stock
index)
has
not
changed
in
a
systemaUc
way
across
Ume.
Aswath
Damodaran
105
B.
The
Historical
Risk
Premium
Evidence
from
the
United
States
106
Aswath
Damodaran
106
What
about
historical
premiums
for
other
markets?
107
Aswath
Damodaran
107
One
soluUon:
Bond
default
spreads
as
CRP
–
November
2013
¨ In
November
2013,
the
historical
risk
premium
for
the
US
was
4.20%
(geometric
average,
stocks
over
T.Bonds,
1928-‐2012)
Arithmetic Average Geometric Average
Stocks - T. Bills Stocks - T. Bonds Stocks - T. Bills Stocks - T. Bonds
1928-2012 7.65% 5.88% 5.74% 4.20%
2.20% 2.33%
¨ Using
the
default
spread
on
the
sovereign
bond
or
based
upon
the
sovereign
raUng
and
adding
that
spread
to
the
mature
market
premium
(4.20%
for
the
US)
gives
you
a
total
ERP
for
a
country.
Country
RaUng
Default
Spread
(Country
Risk
Premium)
US
ERP
Total
ERP
for
country
India
Baa3
2.25%
4.20%
6.45%
China
Aa3
0.80%
4.20%
5.00%
Brazil
Baa2
2.00%
4.20%
6.20%
Aswath Damodaran
108
Beyond
the
default
spread?
EquiUes
are
riskier
than
bonds
¨ While
default
risk
spreads
and
equity
risk
premiums
are
highly
correlated,
one
would
expect
equity
spreads
to
be
higher
than
debt
spreads.
One
approach
to
scaling
up
the
premium
is
to
look
at
the
relaUve
volaUlity
of
equiUes
to
bonds
and
to
scale
up
the
default
spread
to
reflect
this:
¨ Brazil:
The
annualized
standard
deviaUon
in
the
Brazilian
equity
index
over
the
previous
year
is
21
percent,
whereas
the
annualized
standard
deviaUon
in
the
Brazilian
C-‐bond
is
14
percent.
! 21% $
Brazil's Total Risk Premium = 4.20% + 2.00%# & = 7.20%
" 14% %
Equals
Aswath Damodaran Implied Equity Risk Premium (1/1/14) = 8.04% - 2.55% = 5.49%
110
The
boOom
line
on
Equity
Risk
Premiums
in
November
2013
¨ Mature
Markets:
In
November
2013,
the
number
that
we
chose
to
use
as
the
equity
risk
premium
for
all
mature
markets
was
5.5%.
This
was
set
equal
to
the
implied
premium
at
that
point
in
Ume
and
it
was
much
higher
than
the
historical
risk
premium
of
4.20%
prevailing
then
(1928-‐2012
period).
Arithmetic Average Geometric Average
Stocks - T. Bills Stocks - T. Bonds Stocks - T. Bills Stocks - T. Bonds
1928-2012 7.65% 5.88% 5.74% 4.20%
2.20% 2.33%
1962-2012 5.93% 3.91% 4.60% 2.93%
2.38% 2.66%
2002-2012 7.06% 3.08% 5.38% 1.71%
5.82% 8.11%
¨ For
emerging
markets,
we
will
use
the
melded
default
spread
approach
(where
default
spreads
are
scaled
up
to
reflect
addiUonal
equity
risk)
to
come
up
with
the
addiUonal
risk
premium
that
we
will
add
to
the
mature
market
premium.
Thus,
markets
in
countries
with
lower
sovereign
raUngs
will
have
higher
risk
premiums
that
5.5%.
! σ $
Emerging
Market
ERP
=
5.5%
+
Country Default Spread*## Equity
&& !
" σ Country Bond %
Aswath Damodaran
111
A
Composite
way
of
esUmaUng
ERP
for
countries
Step
1:
EsUmate
an
equity
risk
premium
for
a
mature
market.
If
your
preference
is
for
a
forward
looking,
updated
number,
you
can
esUmate
an
implied
equity
risk
premium
for
the
US
(assuming
that
you
buy
into
the
contenUon
that
it
is
a
mature
market)
¤ My
esUmate:
In
November
2013,
my
esUmate
for
the
implied
premium
in
the
US
was
5.5%.
That
will
also
be
my
esUmate
for
a
mature
market
ERP.
Step
2:
Come
up
with
a
generic
and
measurable
definiUon
of
a
mature
market.
¤ My
esUmate:
Any
AAA
rated
country
is
mature.
Step
3:
EsUmate
the
addiUonal
risk
premium
that
you
will
charge
for
markets
that
are
not
mature.
You
have
two
choices:
¤ The
default
spread
for
the
country,
esUmated
based
either
on
sovereign
raUngs
or
the
CDS
market.
¤ A
scaled
up
default
spread,
where
you
adjust
the
default
spread
upwards
for
the
addiUonal
risk
in
equity
markets.
Aswath Damodaran
112
Andorra
7.45%
1.95%
Liechtenstein
5.50%
0.00%
Albania
12.25%
6.75%
ERP : Nov 2013 Austria
5.50%
0.00%
Luxembourg
5.50%
0.00%
Armenia
10.23%
4.73%
Bangladesh
10.90%
5.40%
Belgium
6.70%
1.20%
Malta
7.45%
1.95%
Azerbaijan
8.88%
3.38%
Cambodia
13.75%
8.25%
Cyprus
22.00%
16.50%
Netherlands
5.50%
0.00%
Belarus
15.63%
10.13%
China
6.94%
1.44%
Denmark
5.50%
0.00%
Norway
5.50%
0.00%
Bosnia
15.63%
10.13%
Fiji
12.25%
6.75%
Finland
5.50%
0.00%
Portugal
10.90%
5.40%
Bulgaria
8.50%
3.00%
Hong
Kong
5.95%
0.45%
France
5.95%
0.45%
Spain
8.88%
3.38%
CroaUa
9.63%
4.13%
India
9.10%
3.60%
Czech
Republic
6.93%
1.43%
Germany
5.50%
0.00%
Sweden
5.50%
0.00%
Indonesia
8.88%
3.38%
Estonia
6.93%
1.43%
Greece
15.63%
10.13%
Switzerland
5.50%
0.00%
Japan
6.70%
1.20%
Georgia
10.90%
5.40%
Iceland
8.88%
3.38%
Turkey
8.88%
3.38%
Hungary
9.63%
4.13%
Korea
6.70%
1.20%
Ireland
9.63%
4.13%
United
Kingdom
5.95%
0.45%
Kazakhstan
8.50%
3.00%
Macao
6.70%
1.20%
Italy
8.50%
3.00%
Western
Europe
6.72%
1.22%
Latvia
8.50%
3.00%
Malaysia
7.45%
1.95%
Canada 5.50% 0.00% Lithuania
8.05%
2.55%
MauriUus
8.05%
2.55%
United States of America 5.50% 0.00% Country
TRP
CRP
Macedonia
10.90%
5.40%
Mongolia
12.25%
6.75%
North America 5.50% 0.00% Angola
10.90%
5.40%
Moldova
15.63%
10.13%
Pakistan
17.50%
12.00%
ArgenUna
15.63%
10.13%
Benin
13.75%
8.25%
Montenegro
10.90%
5.40%
Papua
NG
12.25%
6.75%
Belize
19.75%
14.25%
Botswana
7.15%
1.65%
Poland
7.15%
1.65%
Philippines
9.63%
4.13%
Bolivia
10.90%
5.40%
Burkina
Faso
13.75%
8.25%
Romania
8.88%
3.38%
Singapore
5.50%
0.00%
Cameroon
13.75%
8.25%
Russia
8.05%
2.55%
Brazil
8.50%
3.00%
Sri
Lanka
12.25%
6.75%
Cape
Verde
12.25%
6.75%
Serbia
10.90%
5.40%
Chile
6.70%
1.20%
Taiwan
6.70%
1.20%
Egypt
17.50%
12.00%
Slovakia
7.15%
1.65%
Colombia
8.88%
3.38%
Thailand
8.05%
2.55%
Slovenia
9.63%
4.13%
Costa
Rica
8.88%
3.38%
Gabon
10.90%
5.40%
Vietnam
13.75%
8.25%
Ukraine
15.63%
10.13%
Ecuador
17.50%
12.00%
Ghana
12.25%
6.75%
Asia
7.27%
1.77%
E.
Europe
&
Russia
8.60%
3.10%
El
Salvador
10.90%
5.40%
Kenya
12.25%
6.75%
Guatemala
9.63%
4.13%
Morocco
9.63%
4.13%
Bahrain
8.05%
2.55%
Honduras
13.75%
8.25%
Mozambique
12.25%
6.75%
Israel
6.93%
1.43%
Australia
5.50%
0.00%
Mexico
8.05%
2.55%
Namibia
8.88%
3.38%
Jordan
12.25%
6.75%
Cook
Islands
12.25%
6.75%
Nicaragua
15.63%
10.13%
Nigeria
10.90%
5.40%
Kuwait
6.40%
0.90%
New
Zealand
5.50%
0.00%
Panama
8.50%
3.00%
Rwanda
13.75%
8.25%
Lebanon
12.25%
6.75%
Australia
&
NZ
5.50%
0.00%
Paraguay
10.90%
5.40%
Senegal
12.25%
6.75%
Oman
6.93%
1.43%
Peru
8.50%
3.00%
South
Africa
8.05%
2.55%
Qatar
6.40%
0.90%
Suriname
10.90%
5.40%
Tunisia
10.23%
4.73%
Saudi
Arabia
6.70%
1.20%
Uruguay
8.88%
3.38%
Uganda
12.25%
6.75%
United
Arab
Emirates
6.40%
0.90%
Black #: Total ERP
Aswath Damodaran Middle
East
6.88%
1.38%
Red #: Country risk premium
Venezuela
12.25%
6.75%
Zambia
12.25%
6.75%
LaOn
America
9.44%
3.94%
Africa
11.22%
5.82%
AVG: GDP weighted average
EsUmaUng
ERP
for
Disney:
November
2013
¨ IncorporaUon:
The
convenUonal
pracUce
on
equity
risk
premiums
is
to
esUmate
an
ERP
based
upon
where
a
company
is
incorporated.
Thus,
the
cost
of
equity
for
Disney
would
be
computed
based
on
the
US
equity
risk
premium,
because
it
is
a
US
company,
and
the
Brazilian
ERP
would
be
used
for
Vale,
because
it
is
a
Brazilian
company.
¨ OperaUons:
The
more
sensible
pracUce
on
equity
risk
premium
is
to
esUmate
an
ERP
based
upon
where
a
company
operates.
For
Disney
in
2013:
Proportion of Disney’s
Region/ Country ERP
Revenues
US& Canada 82.01%
5.50%
Europe
11.64%
6.72%
Asia-‐Pacific
6.02%
7.27%
LaUn
America
0.33%
9.44%
Disney 100.00% 5.76%
Aswath Damodaran
114
ERP
for
Companies:
November
2013
Company Region/ Country Weight ERP
Bookscape United States 100% 5.50%
US & Canada 4.90% 5.50%
Brazil 16.90% 8.50%
Rest of Latin
1.70% 10.09%
America
China 37.00% 6.94%
Vale
Japan 10.30% 6.70%
In November 2013, Rest of Asia 8.50% 8.61%
the mature market Europe 17.20% 6.72%
Rest of World 3.50% 10.06%
premium used was Company 100.00% 7.38%
5.5% India 23.90% 9.10%
China 23.60% 6.94%
UK 11.90% 5.95%
Tata Motors United States 10.00% 5.50%
Mainland Europe 11.70% 6.85%
Rest of World 18.90% 6.98%
Company 100.00% 7.19%
Baidu China 100% 6.94%
Germany 35.93% 5.50%
North America 24.72% 5.50%
Rest of Europe 28.67% 7.02%
Deutsche Bank
Asia-Pacific 10.68% 7.27%
South America 0.00% 9.44%
Company 100.00%
6.12%
Aswath Damodaran
115
The
Anatomy
of
a
Crisis:
Implied
ERP
from
September
12,
2008
to
January
1,
2009
116
Aswath
Damodaran
116
An
Updated
Equity
Risk
Premium:
January
2014
Equals
Aswath Damodaran
117
118
2013
2012
2011
2010
Implied
Premiums
in
the
US:
1960-‐2013
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
Year
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
1970
1969
1968
1967
Aswath
Damodaran
1966
1965
1964
1963
1962
1961
1960
7.00%
6.00%
5.00%
4.00%
3.00%
2.00%
1.00%
0.00%
Implied Premium
118
Andorra
8.15%
2.40%
Italy
8.60%
2.85%
Albania
12.50%
6.75%
Montenegro
11.15%
5.40%
Austria
5.75%
0.00%
Jersey
6.35%
0.60%
Armenia
10.25%
4.50%
Poland
7.03%
1.28%
Belgium
6.65%
0.90%
Liechtenstein
5.75%
0.00%
ERP : Jan 2015 Azerbaijan
9.05%
3.30%
Romania
9.05%
3.30%
Cyprus
15.50%
9.75%
Luxembourg
5.75%
0.00%
Belarus
15.50%
9.75%
Russia
8.60%
2.85%
Denmark
5.75%
0.00%
Malta
7.55%
1.80%
Bosnia
15.50%
.75%
Serbia
12.50%
6.75%
Finland
5.75%
0.00%
Netherlands
5.75%
0.00%
Bulgaria
8.60%
2.85%
Slovakia
7.03%
1.28%
France
6.35%
0.60%
Norway
5.75%
0.00%
CroaUa
9.50%
3.75%
Slovenia
9.50%
3.75%
Germany
5.75%
0.00%
Portugal
9.50%
3.75%
Czech
Repub
6.80%
1.05%
Ukraine
20.75%
15.00%
Greece
17.00%
11.25%
Spain
8.60%
2.85%
Guernsey
6.35%
0.60%
Sweden
5.75%
0.00%
Estonia
6.80%
1.05%
E.
Europe
9.08%
3.33%
Iceland
9.05%
3.30%
Switzerland
5.75%
0.00%
Georgia
11.15%
5.40%
Bangladesh
11.15%
5.40%
Ireland
8.15%
2.40%
Turkey
9.05%
3.30%
Hungary
9.50%
3.75%
Cambodia
14.00%
8.25%
Isle
of
Man
6.35%
0.60%
UK
6.35%
0.60%
Kazakhstan
8.60%
2.85%
China
6.65%
0.90%
W.
Europe
6.88%
1.13%
Latvia
8.15%
2.40%
Fiji
12.50%
6.75%
Canada
5.75%
0.00%
Lithuania
8.15%
2.40%
Hong
Kong
6.35%
0.60%
US
5.75%
0.00%
Angola
10.25%
4.50%
Macedonia
11.15%
5.40%
India
9.05%
3.30%
North
America
5.75%
0.00%
Botswana
7.03%
1.28%
Moldova
15.50%
9.75%
Indonesia
9.05%
3.30%
Burkina
Faso
15.50%
9.75%
Japan
6.80%
1.05%
ArgenUna
17.00%
11.25%
Cameroon
14.00%
8.25%
Korea
6.65%
0.90%
Cape
Verde
14.00%
8.25%
Belize
19.25%
13.50%
Abu
Dhabi
6.50%
0.75%
Macao
6.50%
0.75%
Congo
(DR)
15.50%
9.75%
Bolivia
11.15%
5.40%
Malaysia
7.55%
1.80%
Congo
(Republic)
11.15%
5.40%
Bahrain
8.60%
2.85%
Brazil
8.60%
2.85%
MauriUus
8.15%
2.40%
Côte
d'Ivoire
12.50%
6.75%
Israel
6.80%
1.05%
Chile
6.65%
0.90%
Egypt
17.00%
11.25%
Mongolia
14.00%
8.25%
Jordan
12.50%
6.75%
Colombia
8.60%
2.85%
Ethiopia
12.50%
6.75%
Kuwait
6.50%
0.75%
Pakistan
17.00%
11.25%
Costa
Rica
9.50%
3.75%
Gabon
11.15%
5.40%
Lebanon
14.00%
8.25%
Papua
New
Guinea
12.50%
6.75%
Ecuador
15.50%
9.75%
Ghana
14.00%
8.25%
Oman
6.80%
1.05%
Philippines
8.60%
2.85%
El
Salvador
11.15%
5.40%
Kenya
12.50%
6.75%
Morocco
9.50%
3.75%
Qatar
6.50%
0.75%
Singapore
5.75%
0.00%
Guatemala
9.50%
3.75%
Honduras
15.50%
9.75%
Mozambique
12.50%
6.75%
Ras
Al
Khaimah
7.03%
1.28%
Sri
Lanka
12.50%
6.75%
Mexico
7.55%
1.80%
Namibia
9.05%
3.30%
Saudi
Arabia
6.65%
0.90%
Taiwan
6.65%
0.90%
Nicaragua
15.50%
9.75%
Nigeria
11.15%
5.40%
Sharjah
7.55%
1.80%
Thailand
8.15%
2.40%
Rwanda
14.00%
8.25%
Vietnam
12.50%
6.75%
Panama
8.60%
2.85%
UAE
6.50%
0.75%
Senegal
12.50%
6.75%
Paraguay
10.25%
4.50%
Middle
East
6.85%
1.10%
Asia
7.26%
1.51%
South
Africa
8.60%
2.85%
Peru
7.55%
1.80%
Tunisia
11.15%
5.40%
Australia
5.75%
0.00%
Suriname
11.15%
5.40%
Uganda
12.50%
6.75%
Black #: Total ERP
Uruguay
8.60%
2.85%
Cook
Islands
12.50%
6.75%
Zambia
12.50%
6.75%
Red #: Country risk premium
Venezuela
17.00%
11.25%
AVG: GDP weighted average New
Zealand
5.75%
0.00%
Africa
11.73%
5.98%
LaOn
America
9.95%
4.20%
Australia
&
NZ
5.75%
0.00%
ApplicaUon
Test:
EsUmaUng
a
Market
Risk
Premium
120
¨ For
your
company,
get
the
geographical
breakdown
of
revenues
in
the
most
recent
year.
Based
upon
this
revenue
breakdown
and
the
most
recent
country
risk
premiums,
esUmate
the
equity
risk
premium
that
you
would
use
for
your
company.
¨ This
computaUon
was
based
enUrely
on
revenues.
With
your
company,
what
concerns
would
you
have
about
your
esUmate
being
too
high
or
too
low?
Aswath
Damodaran
120
EsUmaUng
Beta
121
¨ The
intercept
of
the
regression
provides
a
simple
measure
of
performance
during
the
period
of
the
regression,
relaUve
to
the
capital
asset
pricing
model.
Rj
=
Rf
+
b
(Rm
-‐
Rf)
=
Rf
(1-‐b)
+
b
Rm
...........
Capital
Asset
Pricing
Model
Rj
=
a
+
b
Rm
...........
Regression
EquaUon
¨ If
a
>
Rf
(1-‐b)
....
Stock
did
beOer
than
expected
during
regression
period
a
=
Rf
(1-‐b)
....
Stock
did
as
well
as
expected
during
regression
period
a
<
Rf
(1-‐b)
....
Stock
did
worse
than
expected
during
regression
period
¨ The
difference
between
the
intercept
and
Rf
(1-‐b)
is
Jensen's
alpha.
If
it
is
posiUve,
your
stock
did
perform
beOer
than
expected
during
the
period
of
the
regression.
Aswath
Damodaran
122
Sesng
up
for
the
EsUmaUon
123
Aswath
Damodaran
123
Choosing
the
Parameters:
Disney
Aswath Damodaran
124
Disney’s
Historical
Beta
!
Return
on
Disney
=
.0071
+
1.2517
Return
on
Market
R²
=
0.73386
(0.10)
Analyzing
Disney’s
Performance
¨ If
you
did
this
analysis
on
every
stock
listed
on
an
exchange,
what
would
the
average
Jensen’s
alpha
be
across
all
stocks?
a. Depend
upon
whether
the
market
went
up
or
down
during
the
period
b. Should
be
zero
c. Should
be
greater
than
zero,
because
stocks
tend
to
go
up
more
o^en
than
down.
¨ Disney
has
a
posiUve
Jensen’s
alpha
of
9.02%
a
year
between
2008
and
2013.
This
can
be
viewed
as
a
sign
that
management
in
the
firm
did
a
good
job,
managing
the
firm
during
the
period.
a. True
b. False
¨ Disney
has
had
a
posiUve
Jensen’s
alpha
between
2008
and
2013.
If
you
were
an
investor
in
early
2014,
looking
at
the
stock,
you
would
view
this
as
a
sign
that
the
stock
will
be
a:
a. Good
investment
for
the
future
b. Bad
investment
for
the
future
c. No
informaUon
about
the
future
Aswath
Damodaran
127
EsUmaUng
Disney’s
Beta
¨ Slope
of
the
Regression
of
1.25
is
the
beta
¨ Regression
parameters
are
always
esUmated
with
error.
The
error
is
captured
in
the
standard
error
of
the
beta
esUmate,
which
in
the
case
of
Disney
is
0.10.
¨ Assume
that
I
asked
you
what
Disney’s
true
beta
is,
a^er
this
regression.
¤ What
is
your
best
point
esUmate?
¤ What range would you give me, with 67% confidence?
¤ What range would you give me, with 95% confidence?
Aswath Damodaran
128
The
Dirty
Secret
of
“Standard
Error”
1600
1400
1200
1000
Number of Firms
800
600
400
200
0
<.10 .10 - .20 .20 - .30 .30 - .40 .40 -.50 .50 - .75 > .75
Aswath Damodaran
129
Breaking
down
Disney’s
Risk
¨ The
firm-‐specific
risk
is
diversifiable
and
will
not
be
rewarded.
¨ The
R-‐squared
for
companies,
globally,
has
increased
significantly
since
2008.
Why
might
this
be
happening?
¨
What
are
the
implicaUons
for
investors?
Aswath Damodaran
130
The
Relevance
of
R
Squared
131
¨ Would
your
answer
be
different
if
you
were
an
undiversified
investor?
Aswath
Damodaran
131
Beta
EsUmaUon:
Using
a
Service
(Bloomberg)
Aswath Damodaran
132
EsUmaUng
Expected
Returns
for
Disney
in
November
2013
¨ Inputs
to
the
expected
return
calculaUon
¤ Disney’s
Beta
=
1.25
Aswath Damodaran
133
Use
to
a
PotenUal
Investor
in
Disney
Aswath Damodaran
134
How
managers
use
this
expected
return
Aswath Damodaran
135
ApplicaUon
Test:
Analyzing
the
Risk
Regression
136
¨ Using
your
Bloomberg
risk
and
return
print
out,
answer
the
following
quesUons:
¤ How
well
or
badly
did
your
stock
do,
relaUve
to
the
market,
during
the
period
of
the
regression?
¤ Intercept
-‐
(Riskfree
Rate/n)
(1-‐
Beta)
=
Jensen’s
Alpha
n where
n
is
the
number
of
return
periods
in
a
year
(12
if
monthly;
52
if
weekly)
¤ What
proporUon
of
the
risk
in
your
stock
is
aOributable
to
the
market?
What
proporUon
is
firm-‐specific?
¤ What
is
the
historical
esUmate
of
beta
for
your
stock?
What
is
the
range
on
this
esUmate
with
67%
probability?
With
95%
probability?
¤ Based
upon
this
beta,
what
is
your
esUmate
of
the
required
return
on
this
stock?
¤ Riskless
Rate
+
Beta
*
Risk
Premium
Aswath
Damodaran
136
A
Quick
Test
137
¨ You
are
advising
a
very
risky
so^ware
firm
on
the
right
cost
of
equity
to
use
in
project
analysis.
You
esUmate
a
beta
of
3.0
for
the
firm
and
come
up
with
a
cost
of
equity
of
20%.
The
CFO
of
the
firm
is
concerned
about
the
high
cost
of
equity
and
wants
to
know
whether
there
is
anything
he
can
do
to
lower
his
beta.
¨ How
do
you
bring
your
beta
down?
¨ Should
you
focus
your
aOenUon
on
bringing
your
beta
down?
¤ Yes
¤ No
Aswath
Damodaran
137
Regression
DiagnosUcs
for
Tata
Motors
Beta = 1.83
67% range
1.67-1.99
Jensen’s α
= 2.28% - 4%/12 (1-1.83) = 2.56% Expected Return (in Rupees)
Annualized = (1+.0256)12-1= 35.42% = Riskfree Rate+ Beta*Risk premium
Average monthly riskfree rate (2008-13) = 4% = 6.57%+ 1.83 (7.19%) = 19.73%
Aswath Damodaran
138
A
beOer
beta?
Vale
Aswath Damodaran
139
Deutsche
Bank
and
Baidu:
Index
Effects
on
Risk
Parameters
¨ For
Deutsche
Bank,
a
widely
held
European
stock,
we
tried
both
the
DAX
(German
index)
and
the
FTSE
European
index.
Aswath Damodaran
140
Beta:
Exploring
Fundamentals
141
Beta
between 1 Microsoft: 1.25
and 2
GE: 1.15
Aswath
Damodaran
141
Determinant
1:
Product
Type
142
Aswath
Damodaran
142
A
Simple
Test
143
¨ Phone
service
is
close
to
being
non-‐discreUonary
in
the
United
States
and
Western
Europe.
However,
in
much
of
Asia
and
LaUn
America,
there
are
large
segments
of
the
populaUon
for
which
phone
service
is
a
luxury.
¨ Given
our
discussion
of
discreUonary
and
non-‐
discreUonary
products,
which
of
the
following
conclusions
would
you
be
willing
to
draw:
¤ Emerging
market
telecom
companies
should
have
higher
betas
than
developed
market
telecom
companies.
¤ Developed
market
telecom
companies
should
have
higher
betas
than
emerging
market
telecom
companies
¤ The
two
groups
of
companies
should
have
similar
betas
Aswath
Damodaran
143
Determinant
2:
OperaUng
Leverage
Effects
144
Aswath
Damodaran
144
Measures
of
OperaUng
Leverage
145
Aswath
Damodaran
145
Disney’s
OperaUng
Leverage:
1987-‐
2013
Year Net Sales % Change in EBIT % Change in
Sales EBIT
1987 $2,877 $756
1988 $3,438 19.50% $848 12.17%
1989 $4,594 33.62% $1,177 38.80%
1990 $5,844 27.21% $1,368 16.23%
1991 $6,182 5.78% $1,124 -17.84%
1992 $7,504 21.38% $1,287 14.50%
1993 $8,529 13.66% $1,560 21.21%
1994 $10,055 17.89% $1,804 15.64%
Average across entertainment companies = 1.35
1995 $12,112 20.46% $2,262 25.39%
1996 $18,739 54.71% $3,024 33.69%
1997 $22,473 19.93% $3,945 30.46% Given Disney’s operating leverage measures (1.01
1998
1999
$22,976
$23,435
2.24%
2.00%
$3,843
$3,580
-2.59%
-6.84%
or 1.25), would you expect Disney to have a higher
2000 $25,418 8.46% $2,525 -29.47% or a lower beta than other entertainment
2001 $25,172 -0.97% $2,832 12.16%
2002 $25,329 0.62% $2,384 -15.82% companies?
2003 $27,061 6.84% $2,713 13.80%
2004 $30,752 13.64% $4,048 49.21%
a. Higher
2005 $31,944 3.88% $4,107 1.46% b. Lower
2006 $33,747 5.64% $5,355 30.39%
2007 $35,510 5.22% $6,829 27.53% c. No effect
2008 $37,843 6.57% $7,404 8.42%
2009 $36,149 -4.48% $5,697 -23.06%
2010 $38,063 5.29% $6,726 18.06%
2011 $40,893 7.44% $7,781 15.69%
2012 $42,278 3.39% $8,863 13.91%
2013 $45,041 6.54% $9,450 6.62% Operating Leverage
Average:
87-13 11.79% 11.91% 11.91/11.79 =1.01
Average:
96-13 8.16% 10.20% 10.20/8.16 =1.25
Aswath Damodaran
146
Determinant
3:
Financial
Leverage
147
¨ As
firms
borrow,
they
create
fixed
costs
(interest
payments)
that
make
their
earnings
to
equity
investors
more
volaUle.
This
increased
earnings
volaUlity
which
increases
the
equity
beta.
¨ The
beta
of
equity
alone
can
be
wriOen
as
a
funcUon
of
the
unlevered
beta
and
the
debt-‐equity
raUo
βL
=
βu
(1+
((1-‐t)D/E))
where
¤ βL
=
Levered
or
Equity
Beta
D/E
=
Market
value
Debt
to
equity
raUo
¤ βu
=
Unlevered
or
Asset
Beta
t
=
Marginal
tax
rate
¨ Earlier,
we
esUmated
the
beta
for
Disney
from
a
regression.
Was
that
beta
a
levered
or
unlevered
beta?
a. Levered
b. Unlevered
Aswath
Damodaran
147
Effects
of
leverage
on
betas:
Disney
¨ The
regression
beta
for
Disney
is
1.25.
This
beta
is
a
levered
beta
(because
it
is
based
on
stock
prices,
which
reflect
leverage)
and
the
leverage
implicit
in
the
beta
esUmate
is
the
average
market
debt
equity
raUo
during
the
period
of
the
regression
(2008
to
2013)
¨ The
average
debt
equity
raUo
during
this
period
was
19.44%.
¨ The
unlevered
beta
for
Disney
can
then
be
esUmated
(using
a
marginal
tax
rate
of
36.1%)
=
Current
Beta
/
(1
+
(1
-‐
tax
rate)
(Average
Debt/Equity))
=
1.25
/
(1
+
(1
-‐
0.361)(0.1944))=
1.1119
Aswath Damodaran
148
Disney
:
Beta
and
Financial
Leverage
Aswath Damodaran
149
Betas
are
weighted
Averages
150
¤ the
beta
of
a
mutual
fund
is
the
weighted
average
of
the
betas
of
the
stocks
and
other
investment
in
that
por|olio
¤ the
beta
of
a
firm
a^er
a
merger
is
the
market-‐value
weighted
average
of
the
betas
of
the
companies
involved
in
the
merger.
Aswath
Damodaran
150
The
Disney/Cap
CiUes
Merger
(1996):
Pre-‐
Merger
151
+
Capital Cities: The Target
Debt = $ 615 million
Equity Beta Market value of equity = $18, 500 million
0.95 Debt + Equity = Firm value = $18,500 +
$615 = $19,115 million
D/E Ratio = 615/18500 = 0.03
Aswath
Damodaran
151
Disney
Cap
CiUes
Beta
EsUmaUon:
Step
1
152
Aswath
Damodaran
152
Disney
Cap
CiUes
Beta
EsUmaUon:
Step
2
153
¨ If
Disney
had
used
all
equity
to
buy
Cap
CiUes
equity,
while
assuming
Cap
CiUes
debt,
the
consolidated
numbers
would
have
looked
as
follows:
¤ Debt
=
$
3,186+
$615
=
$
3,801
million
¤ Equity
=
$
31,100
+
$18,500
=
$
49,600
m
(Disney
issues
$18.5
billion
in
equity)
¤ D/E
RaUo
=
3,801/49600
=
7.66%
¤ New
Beta
=
1.026
(1
+
0.64
(.0766))
=
1.08
¨ Since
Disney
borrowed
$
10
billion
to
buy
Cap
CiUes/ABC,
funded
the
rest
with
new
equity
and
assumed
Cap
CiUes
debt:
¤ The
market
value
of
Cap
CiUes
equity
is
$18.5
billion.
If
$
10
billion
comes
from
debt,
the
balance
($8.5
billion)
has
to
come
from
new
equity.
¤ Debt
=
$
3,186
+
$615
million
+
$
10,000
=
$
13,801
million
¤ Equity
=
$
31,100
+
$8,500
=
$39,600
million
¤ D/E
RaUo
=
13,801/39600
=
34.82%
¤ New
Beta
=
1.026
(1
+
0.64
(.3482))
=
1.25
Aswath
Damodaran
153
Firm
Betas
versus
divisional
Betas
154
¨ Firm
Betas
as
weighted
averages:
The
beta
of
a
firm
is
the
weighted
average
of
the
betas
of
its
individual
projects.
¨ Firm
Betas
and
Business
betas:
At
a
broader
level
of
Aswath
Damodaran
154
BoOom-‐up
versus
Top-‐down
Beta
155
Aswath
Damodaran
155
Disney’s
businesses:
The
financial
breakdown
(from
2013
annual
report)
Aswath Damodaran
156
Unlevered
Betas
for
businesses
Unlevered Beta
(1 - Cash/ Firm Value)
Median
€ Company
Cash/
Business
Sample
Median
Median
Median
Unlevered
Firm
Unlevered
Business
Comparable
firms
size
Beta
D/E
Tax
rate
Beta
Value
Beta
US
firms
in
broadcasUng
Media
Networks
business
26
1.43
71.09%
40.00%
1.0024
2.80%
1.0313
Global
firms
in
amusement
park
Parks
&
Resorts
business
20
0.87
46.76%
35.67%
0.6677
4.95%
0.7024
Studio
Entertainment
US
movie
firms
10
1.24
27.06%
40.00%
1.0668
2.96%
1.0993
Aswath Damodaran
157
A
closer
look
at
the
process…
Studio
Entertainment
Betas
Aswath Damodaran
158
Backing
into
a
pure
play
beta:
Studio
Entertainment
159
Disney has $3.93 billion in cash, invested in close to riskless assets (with a beta of zero). You
can compute an unlevered beta for Disney as a company (inclusive of cash):
Aswath Damodaran
160
The
levered
beta:
Disney
and
its
divisions
¨ To
esUmate
the
debt
raUos
for
division,
we
allocate
Disney’s
total
debt
($15,961
million)
to
its
divisions
based
on
idenUfiable
assets.
¨ We
use
the
allocated
debt
to
compute
D/E
raUos
and
levered
betas.
Business
Unlevered
beta
Value
of
business
D/E
ra?o
Levered
beta
Cost
of
Equity
Media
Networks
1.0313
$66,580
10.03%
1.0975
9.07%
Parks
&
Resorts
0.7024
$45,683
11.41%
0.7537
7.09%
Studio
Entertainment
1.0993
$18,234
20.71%
1.2448
9.92%
Consumer
Products
0.6752
$2,952
117.11%
1.1805
9.55%
InteracUve
1.2187
$1,684
41.07%
1.5385
11.61%
Disney
OperaUons
0.9239
$135,132
13.10%
1.0012
8.52%
Aswath Damodaran
161
Discussion
Issue
162
¨ Assume
now
that
you
are
the
CFO
of
Disney.
The
head
of
the
movie
business
has
come
to
you
with
a
new
big
budget
movie
that
he
would
like
you
to
fund.
He
claims
that
his
analysis
of
the
movie
indicates
that
it
will
generate
a
return
on
equity
of
9.5%.
Would
you
fund
it?
¤ Yes.
It
is
higher
than
the
cost
of
equity
for
Disney
as
a
company
¤ No.
It
is
lower
than
the
cost
of
equity
for
the
movie
business.
¤ What
are
the
broader
implicaUons
of
your
choice?
Aswath
Damodaran
162
EsUmaUng
BoOom
Up
Betas
&
Costs
of
Equity:
Vale
Sample' Unlevered'beta' Peer'Group' Value'of' Proportion'of'
Business' Sample' size' of'business' Revenues' EV/Sales' Business' Vale'
Global'firms'in'metals'&'
Metals'&' mining,'Market'cap>$1'
Mining' billion' 48' 0.86' $9,013' 1.97' $17,739' 16.65%'
Global'specialty'
Fertilizers' chemical'firms' 693' 0.99' $3,777' 1.52' $5,741' 5.39%'
Global'transportation'
Logistics' firms' 223' 0.75' $1,644' 1.14' $1,874' 1.76%'
Vale'
Operations' '' '' 0.8440' $47,151' '' $106,543' 100.00%'
Aswath Damodaran
163
Vale:
Cost
of
Equity
CalculaUon
–
in
nominal
$R
¨ To
convert
a
discount
rate
in
one
currency
to
another,
all
you
need
are
expected
inflaUon
rates
in
the
two
currencies.
(1+ $ Cost of Equity)
(1+ Inflation Rate Brazil )
−1
(1+ Inflation Rate US )
¨ From
US
$
to
R$:
If
we
use
2%
as
the
inflaUon
rate
in
US
dollars
and
9%
as
the
inflaUon
€
raUo
in
Brazil,
we
can
convert
Vale’s
US
dollar
cost
of
equity
of
11.23%
to
a
$R
cost
of
equity:
¨ AlternaUvely,
you
can
compute
a
cost
of
equity,
starUng
with
the
$R
riskfree
rate
of
10.18%.
Cost
of
Equity
in
$R
=
=
10.18%
+
1.15
(7.38%)
=
18.67%
Aswath Damodaran
164
BoOom
up
betas
&
Costs
of
Equity:
Tata
Motors
&
Baidu
¨ Tata
Motors:
We
esUmated
an
unlevered
beta
of
0.8601
across
76
publicly
traded
automoUve
companies
(globally)
and
esUmated
a
levered
beta
based
on
Tata
Motor’s
D/E
raUo
of
41.41%
and
a
marginal
tax
rate
of
32.45%
for
India:
Levered
Beta
for
Tata
Motors
=
0.8601
(1
+
(1-‐.3245)
(.4141))
=
1.1007
Cost
of
equity
for
Tata
Motors
(Rs)
=
6.57%
+
1.1007
(7.19%)
=
14.49%
¨ Baidu:
To
esUmate
its
beta,
we
looked
at
42
global
companies
that
derive
all
or
most
of
their
revenues
from
online
adverUsing
and
esUmated
an
unlevered
beta
of
1.30
for
the
business.
IncorporaUng
Baidu’s
current
market
debt
to
equity
raUo
of
5.23%
and
the
marginal
tax
rate
for
China
of
25%,
we
esUmate
Baidu’s
current
levered
beta
to
be
1.3560.
Levered
Beta
for
Baidu
=
1.30
(1
+
(1-‐.25)
(.0523))
=
1.356
Cost
of
Equity
for
Baidu
(Renmimbi)
=
3.50%
+
1.356
(6.94%)
=
12.91%
Aswath Damodaran
165
BoOom
up
Betas
and
Costs
of
Equity:
Deutsche
Bank
¨ We
break
Deutsche
Bank
down
into
two
businesses
–
commercial
and
investment
banking.
¨ We
do
not
unlever
or
relever
betas,
because
esUmaUng
debt
and
equity
for
banks
is
an
exercise
in
fuUlity.
Using
a
riskfree
rate
of
1.75%
(Euro
risk
free
rate)
and
Deutsche’s
ERP
of
6.12%:
Aswath Damodaran
166
EsUmaUng
Betas
for
Non-‐Traded
Assets
167
Aswath
Damodaran
167
Using
comparable
firms
to
esUmate
beta
for
Bookscape
Unlevered beta for book company = 0.8130/ (1+ (1-.4) (.2141)) = 0.7205
Aswath Damodaran Unlevered beta for book business = 0.7205/(1-.05) = 0.7584 168
EsUmaUng
Bookscape
Levered
Beta
and
Cost
of
Equity
¨ Because
the
debt/equity
raUos
used
in
compuUng
levered
betas
are
market
debt
equity
raUos,
and
the
only
debt
equity
raUo
we
can
compute
for
Bookscape
is
a
book
value
debt
equity
raUo,
we
have
assumed
that
Bookscape
is
close
to
the
book
industry
median
market
debt
to
equity
raUo
of
21.41
percent.
¨ Using
a
marginal
tax
rate
of
40
percent
for
Bookscape,
we
get
a
levered
beta
of
0.8558.
Levered
beta
for
Bookscape
=
0.7584[1
+
(1
–
0.40)
(0.2141)]
=
0.8558
¨ Using
a
riskfree
rate
of
2.75%
(US
treasury
bond
rate)
and
an
equity
risk
premium
of
5.5%:
Cost
of
Equity
=
2.75%+
0.8558
(5.5%)
=
7.46%
Aswath Damodaran
169
Is
Beta
an
Adequate
Measure
of
Risk
for
a
Private
Firm?
¨ Beta
measures
the
risk
added
on
to
a
diversified
por|olio.
The
owners
of
most
private
firms
are
not
diversified.
Therefore,
using
beta
to
arrive
at
a
cost
of
equity
for
a
private
firm
will
a. Under
esUmate
the
cost
of
equity
for
the
private
firm
b. Over
esUmate
the
cost
of
equity
for
the
private
firm
c. Could
under
or
over
esUmate
the
cost
of
equity
for
the
private
firm
Aswath Damodaran
170
Total
Risk
versus
Market
Risk
¨ Adjust
the
beta
to
reflect
total
risk
rather
than
market
risk.
This
adjustment
is
a
relaUvely
simple
one,
since
the
R
squared
of
the
regression
measures
the
proporUon
of
the
risk
that
is
market
risk.
¤
Total
Beta
=
Market
Beta
/
CorrelaUon
of
the
sector
with
the
market
¨
In
the
Bookscape
example,
where
the
market
beta
is
0.8558
and
the
median
R-‐squared
of
the
comparable
publicly
traded
firms
is
26.00%;
the
correlaUon
with
the
market
is
50.99%.
Market Beta 0.8558
= = 1.6783
R squared .5099
Aswath Damodaran
171
ApplicaUon
Test:
EsUmaUng
a
BoOom-‐up
Beta
172
¨ Data
Source:
You
can
get
a
lisUng
of
unlevered
betas
by
industry
on
my
web
site
by
going
to
updated
data.
Aswath
Damodaran
172
From
Cost
of
Equity
to
Cost
of
Capital
173
¨ The
cost
of
capital
is
a
composite
cost
to
the
firm
of
raising
financing
to
fund
its
projects.
¨ In
addiUon
to
equity,
firms
can
raise
capital
from
debt
Aswath
Damodaran
173
What
is
debt?
174
Aswath
Damodaran
174
EsUmaUng
the
Cost
of
Debt
175
¨ If
the
firm
has
bonds
outstanding,
and
the
bonds
are
traded,
the
yield
to
maturity
on
a
long-‐term,
straight
(no
special
features)
bond
can
be
used
as
the
interest
rate.
¨ If
the
firm
is
rated,
use
the
raUng
and
a
typical
default
spread
on
bonds
with
that
raUng
to
esUmate
the
cost
of
debt.
¨ If
the
firm
is
not
rated,
¤ and
it
has
recently
borrowed
long
term
from
a
bank,
use
the
interest
rate
on
the
borrowing
or
¤ esUmate
a
syntheUc
raUng
for
the
company,
and
use
the
syntheUc
raUng
to
arrive
at
a
default
spread
and
a
cost
of
debt
¨ The
cost
of
debt
has
to
be
esUmated
in
the
same
currency
as
the
cost
of
equity
and
the
cash
flows
in
the
valuaUon.
Aswath
Damodaran
175
The
easy
route:
Outsourcing
the
measurement
of
default
risk
¨ For
those
firms
that
have
bond
raUngs
from
global
raUngs
agencies,
I
used
those
raUngs:
Company S&P Rating Risk-Free Rate Default Spread Cost of Debt
Disney A 2.75% (US $) 1.00% 3.75%
Deutsche Bank A 1.75% (Euros) 1.00% 2.75%
Vale A- 2.75% (US $) 1.30% 4.05%
¨ If
you
want
to
esUmate
Vale’s
cost
of
debt
in
$R
terms,
we
can
again
use
the
differenUal
inflaUon
approach
we
used
for
the
cost
of
equity:
Aswath Damodaran
176
A
more
general
route:
EsUmaUng
SyntheUc
RaUngs
¨ The
raUng
for
a
firm
can
be
esUmated
using
the
financial
characterisUcs
of
the
firm.
In
its
simplest
form,
we
can
use
just
the
interest
coverage
raUo:
Interest
Coverage
RaUo
=
EBIT
/
Interest
Expenses
¨ For
the
non-‐financial
service
companies,
we
obtain
the
following:
Company Operating income Interest Expense Interest coverage ratio
Disney $10.023 $444 22.57
Vale $15,667 $1,342 11.67
Tata Motors Rs 166,605 Rs 36,972 4.51
Baidu CY 11,193 CY 472 23.72
Bookscape $2,536 $492 5.16
Aswath Damodaran
177
Interest
Coverage
RaUos,
RaUngs
and
Default
Spreads-‐
November
2013
Aswath Damodaran
179
EsUmaUng
Cost
of
Debt
¨ For
Bookscape,
we
will
use
the
syntheUc
raUng
(A-‐)
to
esUmate
the
cost
of
debt:
¤ Default
Spread
based
upon
A-‐
raUng
=
1.30%
¤ Pre-‐tax
cost
of
debt
=
Riskfree
Rate
+
Default
Spread
=
2.75%
+
1.30%
=
4.05%
¤ A^er-‐tax
cost
of
debt
=
Pre-‐tax
cost
of
debt
(1-‐
tax
rate)
=
4.05%
(1-‐.40)
=
2.43%
¨ For
the
three
publicly
traded
firms
that
are
rated
in
our
sample,
we
will
use
the
actual
bond
raUngs
to
esUmate
the
costs
of
debt.
Company S&P Rating Risk-Free Rate Default Spread Cost of Debt Tax Rate After-Tax Cost of Debt
Disney A 2.75% (US $) 1.00% 3.75% 36.1% 2.40%
Deutsche Bank A 1.75% (Euros) 1.00% 2.75% 29.48% 1.94%
Vale A- 2.75% (US $) 1.30% 4.05% 34% 2.67%
¨ For
Tata
Motors,
we
have
a
raUng
of
AA-‐
from
CRISIL,
an
Indian
bond-‐
raUng
firm,
that
measures
only
company
risk.
Using
that
raUng:
Cost
of
debtTMT
=
Risk
free
rateRupees
+
Default
spreadIndia
+
Default
spreadTMT
=
6.57%
+
2.25%
+
0.70%
=
9.62%
A^er-‐tax
cost
of
debt
=
9.62%
(1-‐.3245)
=
6.50%
Aswath Damodaran
180
Updated
Default
Spreads
–
January
2015
Aswath Damodaran
181
ApplicaUon
Test:
EsUmaUng
a
Cost
of
Debt
182
¤ A
syntheUc
raUng
for
your
firm
(use
the
tables
from
prior
pages)
¤ A
pre-‐tax
cost
of
debt
for
your
firm
Aswath
Damodaran
182
Costs
of
Hybrids
183
Aswath
Damodaran
183
Weights
for
Cost
of
Capital
CalculaUon
184
¨ The
weights
used
in
the
cost
of
capital
computaUon
should
be
market
values.
¨ There
are
three
specious
arguments
used
against
market
value
¤ Book
value
is
more
reliable
than
market
value
because
it
is
not
as
volaUle:
While
it
is
true
that
book
value
does
not
change
as
much
as
market
value,
this
is
more
a
reflecUon
of
weakness
than
strength
¤ Using
book
value
rather
than
market
value
is
a
more
conservaUve
approach
to
esUmaUng
debt
raUos:
For
most
companies,
using
book
values
will
yield
a
lower
cost
of
capital
than
using
market
value
weights.
¤ Since
accounUng
returns
are
computed
based
upon
book
value,
consistency
requires
the
use
of
book
value
in
compuUng
cost
of
capital:
While
it
may
seem
consistent
to
use
book
values
for
both
accounUng
return
and
cost
of
capital
calculaUons,
it
does
not
make
economic
sense.
Aswath
Damodaran
184
Disney:
From
book
value
to
market
value
for
interest
bearing
debt…
¨ In
Disney’s
2013
financial
statements,
the
debt
due
over
Ume
was
footnoted.
Weight
Time due Amount due Weight
*Maturity
0.5 $1,452 11.96% 0.06
The debt in this table does
2 $1,300 10.71% 0.21
not add up to the book value
3 $1,500 12.36% 0.37
of debt, because Disney
4 $2,650 21.83% 0.87
6 $500 4.12% 0.25 does not break down the
8 $1,362 11.22% 0.9 maturity of all of its debt.
9 $1,400 11.53% 1.04
19 $500 4.12% 0.78
26 $25 0.21% 0.05
28 $950 7.83% 2.19
29 $500 4.12% 1.19
$12,139 7.92
¨ Disney’s
total
debt
due,
in
book
value
terms,
on
the
balance
sheet
is
$14,288
million
and
the
total
interest
expense
for
the
year
was
$349
million.
Using
3.75%
as
the
pre-‐tax
cost
of
debt:
" 1 %
$ (1− (1.0375) '
¨ EsUmated
MV
of
Disney
Debt
=
349 $ 7.92
'+
14, 288
= $13, 028 million
7.92
$ .0375 ' (1.0375)
$# '&
Aswath Damodaran
185
OperaUng
Leases
at
Disney
¨ The
“debt
value”
of
operaUng
leases
is
the
present
value
of
the
lease
payments,
at
a
rate
that
reflects
their
risk,
usually
the
pre-‐tax
cost
of
debt.
¨ The
pre-‐tax
cost
of
debt
at
Disney
is
3.75%.
Year Commitment Present Value @3.75%
1 $507.00 $488.67 Disney reported $1,784 million
2 $422.00 $392.05 in commitments after year 5.
3 $342.00 $306.24 Given that their average
4 $272.00 $234.76 commitment over the first 5
5 $217.00 $180.52 years, we assumed 5 years @
6-10 $356.80 $1,330.69 $356.8 million each.
Debt value of leases $2,932.93
¨ Debt
outstanding
at
Disney
=
$13,028
+
$
2,933=
$15,961
million
Aswath Damodaran
186
ApplicaUon
Test:
EsUmaUng
Market
Value
187
Aswath
Damodaran
187
Current
Cost
of
Capital:
Disney
¨ Equity
¤ Cost
of
Equity
=
Riskfree
rate
+
Beta
*
Risk
Premium
=
2.75%
+
1.0013
(5.76%)
=
8.52%
¤ Market
Value
of
Equity
=
$121,878
million
¤ Equity/(Debt+Equity
)
=
88.42%
¨ Debt
¤ A^er-‐tax
Cost
of
debt
=(Riskfree
rate
+
Default
Spread)
(1-‐t)
=
(2.75%+1%)
(1-‐.361)
=
2.40%
¤ Market
Value
of
Debt
=
$13,028+
$2933
=
$
15,961
million
¤ Debt/(Debt
+Equity)
=
11.58%
¨ Cost
of
Capital
=
8.52%(.8842)+
2.40%(.1158)
=
7.81%
Aswath Damodaran
121,878/ (121,878+15,961)
188
Divisional
Costs
of
Capital:
Disney
and
Vale
Disney
Cost!of! Cost!of! Marginal!tax! After6tax!cost!of! Debt! Cost!of!
!! equity! debt! rate!
debt! ratio! capital!
Media!Networks! 9.07%! 3.75%! 36.10%! 2.40%! 9.12%! 8.46%!
Parks!&!Resorts!
Studio!
7.09%! 3.75%!
36.10%! 2.40%! 10.24%! 6.61%!
Entertainment!
Consumer!Products!
9.92%!
9.55%!
3.75%!
3.75%!
36.10%!
36.10%!
2.40%! 17.16%!
2.40%! 53.94%!
8.63%!
5.69%!
Interactive! 11.65%! 3.75%! 36.10%! 2.40%! 29.11%! 8.96%!
Disney!Operations! 8.52%! 3.75%!
36.10%! 2.40%! 11.58%! 7.81%!
Vale
Cost of After-tax cost of Debt Cost of capital (in Cost of capital (in
Business equity debt ratio US$) $R)
Metals &
Mining 11.35% 2.67% 35.48% 8.27% 15.70%
Iron Ore 11.13% 2.67% 35.48% 8.13% 15.55%
Fertilizers 12.70% 2.67% 35.48% 9.14% 16.63%
Logistics 10.29% 2.67% 35.48% 7.59% 14.97%
Vale Operations 11.23% 2.67% 35.48% 8.20% 15.62%
Aswath Damodaran
189
Costs
of
Capital:
Tata
Motors,
Baidu
and
Bookscape
¨ To
esUmate
the
costs
of
capital
for
Tata
Motors
in
Indian
rupees:
Cost
of
capital=
14.49%
(1-‐.2928)
+
6.50%
(.2928)
=
12.15%
¨ For
Baidu,
we
follow
the
same
path
to
esUmate
a
cost
of
equity
in
Chinese
RMB:
Cost
of
capital
=
12.91%
(1-‐.0523)
+
3.45%
(.0523)
=
12.42%
¨ For
Bookscape,
the
cost
of
capital
is
different
depending
on
whether
you
look
at
market
or
total
beta:
Cost of After-tax cost of
equity Pre-tax Cost of debt debt D/(D+E) Cost of capital
Market Beta 7.46% 4.05% 2.43% 17.63% 6.57%
Total Beta 11.98% 4.05% 2.43% 17.63% 10.30%
Aswath Damodaran
190
ApplicaUon
Test:
EsUmaUng
Cost
of
Capital
191
¨ Using
the
boOom-‐up
unlevered
beta
that
you
computed
for
your
firm,
and
the
values
of
debt
and
equity
you
have
esUmated
for
your
firm,
esUmate
a
boOom-‐up
levered
beta
and
cost
of
equity
for
your
firm.
¨ Based
upon
the
costs
of
equity
and
debt
that
you
have
esUmated,
and
the
weights
for
each,
esUmate
the
cost
of
capital
for
your
firm.
¨ How
different
would
your
cost
of
capital
have
been,
if
you
used
book
value
weights?
Aswath
Damodaran
191
Choosing
a
Hurdle
Rate
192
¨ Either
the
cost
of
equity
or
the
cost
of
capital
can
be
used
as
a
hurdle
rate,
depending
upon
whether
the
returns
measured
are
to
equity
investors
or
to
all
claimholders
on
the
firm
(capital)
¨ If
returns
are
measured
to
equity
investors,
the
Aswath
Damodaran
192
Back
to
First
Principles
193
The hurdle rate The return How much How you choose
should reflect the The optimal The right kind
should relfect the cash you can to return cash to
riskiness of the mix of debt of debt
magnitude and return the owners will
investment and and equity matches the
the timing of the depends upon depend whether
the mix of debt maximizes firm tenor of your
cashflows as welll current & they prefer
and equity used value assets
as all side effects. potential dividends or
to fund it. investment buybacks
opportunities
Aswath
Damodaran
193
Aswath
Damodaran
194
The hurdle rate The return should How much How you choose
should reflect the The optimal The right kind
reflect the cash you can to return cash to
riskiness of the mix of debt of debt
magnitude and return the owners will
investment and and equity matches the
the timing of the depends upon depend on
the mix of debt maximizes firm tenor of your
cashflows as welll current & whether they
and equity used value assets
as all side effects. potential prefer dividends
to fund it. investment or buybacks
opportunities
Aswath
Damodaran
195
Measures
of
return:
earnings
versus
cash
flows
196
Aswath
Damodaran
196
Measuring
Returns
Right:
The
Basic
Principles
197
¨ Use
cash
flows
rather
than
earnings.
You
cannot
spend
earnings.
¨ Use
“incremental”
cash
flows
relaUng
to
the
investment
decision,
i.e.,
cashflows
that
occur
as
a
consequence
of
the
decision,
rather
than
total
cash
flows.
¨ Use
“Ume
weighted”
returns,
i.e.,
value
cash
flows
that
occur
earlier
more
than
cash
flows
that
occur
later.
The
Return
Mantra:
“Time-‐weighted,
Incremental
Cash
Flow
Return”
Aswath
Damodaran
197
Sesng
the
table:
What
is
an
investment/
project?
198
¨ Rio
Disney:
We
will
consider
whether
Disney
should
invest
in
its
first
theme
parks
in
South
America.
These
parks,
while
similar
to
those
that
Disney
has
in
other
parts
of
the
world,
will
require
us
to
consider
the
effects
of
country
risk
and
currency
issues
in
project
analysis.
¨ New
iron
ore
mine
for
Vale:
This
is
an
iron
ore
mine
that
Vale
is
considering
in
Western
Labrador,
Canada.
¨ An
Online
Store
for
Bookscape:
Bookscape
is
evaluaUng
whether
it
should
create
an
online
store
to
sell
books.
While
it
is
an
extension
of
their
basis
business,
it
will
require
different
investments
(and
potenUally
expose
them
to
different
types
of
risk).
¨ AcquisiUon
of
Harman
by
Tata
Motors:
A
cross-‐border
bid
by
Tata
for
Harman
InternaUonal,
a
publicly
traded
US
firm
that
manufactures
high-‐
end
audio
equipment,
with
the
intent
of
upgrading
the
audio
upgrades
on
Tata
Motors’
automobiles.
This
investment
will
allow
us
to
examine
currency
and
risk
issues
in
such
a
transacUon.
Aswath
Damodaran
199
Earnings
versus
Cash
Flows:
A
Disney
Theme
Park
200
¨ The
theme
parks
to
be
built
near
Rio,
modeled
on
Euro
Disney
in
Paris
and
Disney
World
in
Orlando.
¨ The
complex
will
include
a
“Magic
Kingdom”
to
be
constructed,
beginning
immediately,
and
becoming
operaUonal
at
the
beginning
of
the
second
year,
and
a
second
theme
park
modeled
on
Epcot
Center
at
Orlando
to
be
constructed
in
the
second
and
third
year
and
becoming
operaUonal
at
the
beginning
of
the
fourth
year.
¨ The
earnings
and
cash
flows
are
esUmated
in
nominal
U.S.
Dollars.
Aswath
Damodaran
200
Key
AssumpUons
on
Start
Up
and
ConstrucUon
201
¨ Disney
has
already
spent
$0.5
Billion
researching
the
proposal
and
gesng
the
necessary
licenses
for
the
park;
none
of
this
investment
can
be
recovered
if
the
park
is
not
built.
This
expenditure
has
been
capitalized
and
will
be
depreciated
straight
line
over
ten
years
to
a
salvage
value
of
zero.
¨ Disney
will
face
substanUal
construcUon
costs,
if
it
chooses
to
build
the
theme
parks.
¤ The
cost
of
construcUng
Magic
Kingdom
will
be
$3
billion,
with
$
2
billion
to
be
spent
right
now,
and
$1
Billion
to
be
spent
one
year
from
now.
¤ The
cost
of
construcUng
Epcot
II
will
be
$
1.5
billion,
with
$
1
billion
to
be
spent
at
the
end
of
the
second
year
and
$0.5
billion
at
the
end
of
the
third
year.
¤ These
investments
will
be
depreciated
based
upon
a
depreciaUon
schedule
in
the
tax
code,
where
depreciaUon
will
be
different
each
year.
Aswath
Damodaran
201
Key
Revenue
AssumpUons
202
¨ Revenue
esUmates
for
the
parks
and
resort
properUes
(in
millions)
Year
Magic
Kingdom
Epcot
II
Resort
ProperUes
Total
1
$0
$0
$0
$0
2
$1,000
$0
$250
$1,250
3
$1,400
$0
$350
$1.750
4
$1,700
$300
$500
$2.500
5
$2,000
$500
$625
$3.125
6
$2,200
$550
$688
$3,438
7
$2,420
$605
$756
$3,781
8
$2,662
$666
$832
$4,159
9
$2,928
$732
$915
$4,575
10
$2,987
$747
$933
$4,667
¨
Aswath
Damodaran
202
Key
Expense
AssumpUons
203
¨ The
operaUng
expenses
are
assumed
to
be
60%
of
the
revenues
at
the
parks,
and
75%
of
revenues
at
the
resort
properUes.
¨ Disney
will
also
allocate
corporate
general
and
Aswath
Damodaran
204
Other
AssumpUons
205
Aswath
Damodaran
205
Laying
the
groundwork:
Book
Capital,
Working
Capital
and
DepreciaUon
206
12.5% of book
value at end of
prior year
($3,000)
Aswath
Damodaran
206
Step
1:
EsUmate
AccounUng
Earnings
on
Project
207
Aswath
Damodaran
207
And
the
AccounUng
View
of
Return
208
¨ The
exchange
rate
risk
should
be
diversifiable
risk
(and
hence
should
not
command
a
premium)
if
¤ the
company
has
projects
is
a
large
number
of
countries
(or)
¤ the
investors
in
the
company
are
globally
diversified.
¤ For
Disney,
this
risk
should
not
affect
the
cost
of
capital
used.
Consequently,
we
would
not
adjust
the
cost
of
capital
for
Disney’s
investments
in
other
mature
markets
(Germany,
UK,
France)
¨ The
same
diversificaUon
argument
can
also
be
applied
against
some
poliUcal
risk,
which
would
mean
that
it
too
should
not
affect
the
discount
rate.
However,
there
are
aspects
of
poliUcal
risk
especially
in
emerging
markets
that
will
be
difficult
to
diversify
and
may
affect
the
cash
flows,
by
reducing
the
expected
life
or
cash
flows
on
the
project.
¨ For
Disney,
this
is
the
risk
that
we
are
incorporaUng
into
the
cost
of
capital
when
it
invests
in
Brazil
(or
any
other
emerging
market)
Aswath
Damodaran
210
Should
there
be
a
risk
premium
for
foreign
projects?
¨ The
exchange
rate
risk
should
be
diversifiable
risk
(and
hence
should
not
command
a
premium)
if
¤ the
company
has
projects
is
a
large
number
of
countries
(or)
¤ the
investors
in
the
company
are
globally
diversified.
¤ For
Disney,
this
risk
should
not
affect
the
cost
of
capital
used.
Consequently,
we
would
not
adjust
the
cost
of
capital
for
Disney’s
investments
in
other
mature
markets
(Germany,
UK,
France)
¨ The
same
diversificaUon
argument
can
also
be
applied
against
some
poliUcal
risk,
which
would
mean
that
it
too
should
not
affect
the
discount
rate.
However,
there
are
aspects
of
poliUcal
risk
especially
in
emerging
markets
that
will
be
difficult
to
diversify
and
may
affect
the
cash
flows,
by
reducing
the
expected
life
or
cash
flows
on
the
project.
¨ For
Disney,
this
is
the
risk
that
we
are
incorporaUng
into
the
cost
of
capital
when
it
invests
in
Brazil
(or
any
other
emerging
market)
Aswath Damodaran
211
EsUmaUng
a
hurdle
rate
for
Rio
Disney
¨ We
did
esUmate
a
cost
of
capital
of
6.61%
for
the
Disney
theme
park
business,
using
a
boOom-‐up
levered
beta
of
0.7537
for
the
business.
¨ This
cost
of
equity
may
not
adequately
reflect
the
addiUonal
risk
associated
with
the
theme
park
being
in
an
emerging
market.
¨ The
only
concern
we
would
have
with
using
this
cost
of
equity
for
this
project
is
that
it
may
not
adequately
reflect
the
addiUonal
risk
associated
with
the
theme
park
being
in
an
emerging
market
(Brazil).
We
first
computed
the
Brazil
country
risk
premium
(by
mulUplying
the
default
spread
for
Brazil
by
the
relaUve
equity
market
volaUlity)
and
then
re-‐
esUmated
the
cost
of
equity:
¤ Country
risk
premium
for
Brazil
=
5.5%+
3%
=
8.5%
¤ Cost
of
Equity
in
US$=
2.75%
+
0.7537
(8.5%)
=
9.16%
¨ Using
this
esUmate
of
the
cost
of
equity,
Disney’s
theme
park
debt
raUo
of
10.24%
and
its
a^er-‐tax
cost
of
debt
of
2.40%
(see
chapter
4),
we
can
esUmate
the
cost
of
capital
for
the
project:
¤ Cost
of
Capital
in
US$
=
9.16%
(0.8976)
+
2.40%
(0.1024)
=
8.46%
Aswath Damodaran
212
Would
lead
us
to
conclude
that...
¨ Do
not
invest
in
this
park.
The
return
on
capital
of
4.18%
is
lower
than
the
cost
of
capital
for
theme
parks
of
8.46%;
This
would
suggest
that
the
project
should
not
be
taken.
¨ Given
that
we
have
computed
the
average
over
an
¤ No
Aswath Damodaran
213
A
Tangent:
From
New
to
ExisUng
Investments:
ROC
for
the
enUre
firm
Assets Liabilities
Existing Investments Fixed Claim on cash flows
Generate cashflows today Assets in Place Debt Little or No role in management
How “good” are the Includes long lived (fixed) and Fixed Maturity
short-lived(working Tax Deductible
existing investments capital) assets
of the firm?
Expected Value that will be Growth Assets Equity Residual Claim on cash flows
created by future investments Significant Role in management
Perpetual Lives
Aswath Damodaran
214
Old
wine
in
a
new
boOle..
Another
way
of
presenUng
the
same
results…
¨ The
key
to
value
is
earning
excess
returns.
Over
Ume,
there
have
been
aOempts
to
restate
this
obvious
fact
in
new
and
different
ways.
For
instance,
Economic
Value
Added
(EVA)
developed
a
wide
following
in
the
the
1990s:
¨ EVA
=
(ROC
–
Cost
of
Capital
)
(Book
Value
of
Capital
Invested)
¨ The
excess
returns
for
the
four
firms
can
be
restated
as
follows:
Aswath Damodaran
215
Return
Spreads
Globally….
216
216
6
ApplicaUon
Test:
Assessing
Investment
Quality
¨ For
the
most
recent
period
for
which
you
have
data,
compute
the
a^er-‐tax
return
on
capital
earned
by
your
firm,
where
a^er-‐tax
return
on
capital
is
computed
to
be
¨ A^er-‐tax
ROC
=
EBIT
(1-‐tax
rate)/
(BV
of
debt
+
BV
of
Equity-‐Cash)previous
year
¨ For
the
most
recent
period
for
which
you
have
data,
compute
the
return
spread
earned
by
your
firm:
¨ Return
Spread
=
A^er-‐tax
ROC
-‐
Cost
of
Capital
¨ For
the
most
recent
period,
compute
the
EVA
earned
by
your
firm
EVA
=
Return
Spread
*
((BV
of
debt
+
BV
of
Equity-‐
Cash)previous
year
Aswath Damodaran
217
The
cash
flow
view
of
this
project..
0 1 2 3 4 5 6 7 8 9 10
After-tax Operating Income
-‐$32
-‐$96
-‐$54
$68
$202
$249
$299
$352
$410
$421
+ Depreciation & Amortization $0
$50
$425
$469
$444
$372
$367
$364
$364
$366
$368
- Capital Expenditures $2,500
$1,000
$1,188
$752
$276
$258
$285
$314
$330
$347
$350
- Change in non-cash Work Capital $0 $63 $25 $38 $31 $16 $17 $19 $21 $5
Cashflow to firm ($2,500) ($982) ($921) ($361) $198 $285 $314 $332 $367 $407 $434
Aswath Damodaran
218
The
DepreciaUon
Tax
Benefit
219
¨ While
depreciaUon
reduces
taxable
income
and
taxes,
it
does
not
reduce
the
cash
flows.
¨ The
benefit
of
depreciaUon
is
therefore
the
tax
benefit.
In
general,
the
tax
benefit
from
depreciaUon
can
be
wriOen
as:
¨ Tax
Benefit
=
DepreciaUon
*
Tax
Rate
¨ Disney
Theme
Park:
DepreciaUon
tax
savings
(Tax
rate
=
36.1%)
1
2
3
4
5
6
7
8
9
10
Depreciation $50
$425
$469
$444
$372
$367
$364
$364
$366
$368
Tax Bendfits from Depreciation $18
$153
$169
$160
$134
$132
$132
$132
$132
$133
¨ ProposiUon
1:
The
tax
benefit
from
depreciaUon
and
other
non-‐cash
charges
is
greater,
the
higher
your
tax
rate.
¨ ProposiUon
2:
Non-‐cash
charges
that
are
not
tax
deducUble
(such
as
amorUzaUon
of
goodwill)
and
thus
provide
no
tax
benefits
have
no
effect
on
cash
flows.
Aswath
Damodaran
219
DepreciaUon
Methods
220
Aswath
Damodaran
220
The
Capital
Expenditures
Effect
221
¨ Assume
that
you
run
your
own
so^ware
business,
and
that
you
have
an
expense
this
year
of
$
100
million
from
producing
and
distribuUon
promoUonal
CDs
in
so^ware
magazines.
Your
accountant
tells
you
that
you
can
expense
this
item
or
capitalize
and
depreciate
it
over
three
years.
Which
will
have
a
more
posiUve
effect
on
income?
¤ Expense
it
¤ Capitalize
and
Depreciate
it
¨ Which
will
have
a
more
posiUve
effect
on
cash
flows?
¤ Expense
it
¤ Capitalize
and
Depreciate
it
Aswath
Damodaran
222
The
Working
Capital
Effect
223
¨ IntuiUvely,
money
invested
in
inventory
or
in
accounts
receivable
cannot
be
used
elsewhere.
It,
thus,
represents
a
drain
on
cash
flows
¨ To
the
degree
that
some
of
these
investments
can
be
financed
using
supplier
credit
(accounts
payable),
the
cash
flow
drain
is
reduced.
¨ Investments
in
working
capital
are
thus
cash
ou|lows
¤ Any
increase
in
working
capital
reduces
cash
flows
in
that
year
¤ Any
decrease
in
working
capital
increases
cash
flows
in
that
year
¨ To
provide
closure,
working
capital
investments
need
to
be
salvaged
at
the
end
of
the
project
life.
¨ ProposiUon
1:
The
failure
to
consider
working
capital
in
a
capital
budgeUng
project
will
overstate
cash
flows
on
that
project
and
make
it
look
more
aOracUve
than
it
really
is.
¨ ProposiUon
2:
Other
things
held
equal,
a
reducUon
in
working
capital
requirements
will
increase
the
cash
flows
on
all
projects
for
a
firm.
Aswath
Damodaran
223
The
incremental
cash
flows
on
the
project
Aswath Damodaran
224
A
more
direct
way
of
gesng
to
incremental
cash
flows
225
0 1 2 3 4 5 6 7 8 9 10
Revenues $0 $1,250 $1,750 $2,500 $3,125 $3,438 $3,781 $4,159 $4,575 $4,667
Direct Expenses $0 $788 $1,103 $1,575 $1,969 $2,166 $2,382 $2,620 $2,882 $2,940
Incremental Depreciation $0 $375 $419 $394 $322 $317 $314 $314 $316 $318
Incremental G&A $0 $63 $88 $125 $156 $172 $189 $208 $229 $233
Incremental Operating Income $0 $25 $141 $406 $678 $783 $896 $1,017 $1,148 $1,175
- Taxes $0 $9 $51 $147 $245 $283 $323 $367 $415 $424
Incremental after-tax Operating income $0 $16 $90 $260 $433 $500 $572 $650 $734 $751
+ Incremental Depreciation $0 $375 $419 $394 $322 $317 $314 $314 $316 $318
- Capital Expenditures $2,000 $1,000 $1,188 $752 $276 $258 $285 $314 $330 $347 $350
- Change in non-cash Working Capital $0 $63 $25 $38 $31 $16 $17 $19 $21 $5
Cashflow to firm ($2,000) ($1,000) ($859) ($267) $340 $466 $516 $555 $615 $681 $715
Aswath
Damodaran
225
Sunk
Costs
226
¨ What
is
a
sunk
cost?
Any
expenditure
that
has
already
been
incurred,
and
cannot
be
recovered
(even
if
a
project
is
rejected)
is
called
a
sunk
cost.
A
test
market
for
a
consumer
product
and
R&D
expenses
for
a
drug
(for
a
pharmaceuUcal
company)
would
be
good
examples.
¨ The
sunk
cost
rule:
When
analyzing
a
project,
sunk
costs
should
not
be
considered
since
they
are
not
incremental.
¨ A
Behavioral
Aside:
It
is
a
well
established
finding
in
psychological
and
behavioral
research
that
managers
find
it
almost
impossible
to
ignore
sunk
costs.
Aswath
Damodaran
226
Test
MarkeUng
and
R&D:
The
Quandary
of
Sunk
Costs
227
Aswath
Damodaran
227
Allocated
Costs
228
¨ Assume
that
you
have
a
Ume
series
of
revenues
and
G&A
costs
for
a
company.
Aswath
Damodaran
229
To
Time-‐Weighted
Cash
Flows
230
¨ Incremental
cash
flows
in
the
earlier
years
are
worth
more
than
incremental
cash
flows
in
later
years.
¨ In
fact,
cash
flows
across
Ume
cannot
be
added
up.
They
have
to
be
brought
to
the
same
point
in
Ume
before
aggregaUon.
¨ This
process
of
moving
cash
flows
through
Ume
is
¤ discounUng,
when
future
cash
flows
are
brought
to
the
present
¤ compounding,
when
present
cash
flows
are
taken
to
the
future
Aswath
Damodaran
230
Present
Value
Mechanics
231
Aswath
Damodaran
231
Discounted
cash
flow
measures
of
return
232
¨ Net
Present
Value
(NPV):
The
net
present
value
is
the
sum
of
the
present
values
of
all
cash
flows
from
the
project
(including
iniUal
investment).
¤ NPV
=
Sum
of
the
present
values
of
all
cash
flows
on
the
project,
including
the
iniUal
investment,
with
the
cash
flows
being
discounted
at
the
appropriate
hurdle
rate
(cost
of
capital,
if
cash
flow
is
cash
flow
to
the
firm,
and
cost
of
equity,
if
cash
flow
is
to
equity
investors)
¤ Decision
Rule:
Accept
if
NPV
>
0
¨ Internal
Rate
of
Return
(IRR):
The
internal
rate
of
return
is
the
discount
rate
that
sets
the
net
present
value
equal
to
zero.
It
is
the
percentage
rate
of
return,
based
upon
incremental
Ume-‐weighted
cash
flows.
¤ Decision
Rule:
Accept
if
IRR
>
hurdle
rate
Aswath
Damodaran
232
Closure
on
Cash
Flows
¨ In
a
project
with
a
finite
and
short
life,
you
would
need
to
compute
a
salvage
value,
which
is
the
expected
proceeds
from
selling
all
of
the
investment
in
the
project
at
the
end
of
the
project
life.
It
is
usually
set
equal
to
book
value
of
fixed
assets
and
working
capital
¨ In
a
project
with
an
infinite
or
very
long
life,
we
compute
cash
flows
for
a
reasonable
period,
and
then
compute
a
terminal
value
for
this
project,
which
is
the
present
value
of
all
cash
flows
that
occur
a^er
the
esUmaUon
period
ends..
¨ Assuming
the
project
lasts
forever,
and
that
cash
flows
a^er
year
10
grow
2%
(the
inflaUon
rate)
forever,
the
present
value
at
the
end
of
year
10
of
cash
flows
a^er
that
can
be
wriOen
as:
¤ Terminal
Value
in
year
10=
CF
in
year
11/(Cost
of
Capital
-‐
Growth
Rate)
=715
(1.02)
/(.0846-‐.02)
=
$
11,275
million
Aswath Damodaran
233
Which
yields
a
NPV
of..
Aswath Damodaran
235
The
IRR
of
this
project
$5,000.00
$4,000.00
$3,000.00
$2,000.00
Internal Rate of Return=12.60%
NPV
$1,000.00
$0.00
8% 9% 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% 21% 22% 23% 24% 25% 26% 27% 28% 29% 30%
-$1,000.00
-$2,000.00
-$3,000.00
Discount Rate
Aswath Damodaran
236
The
IRR
suggests..
¨ The
project
is
a
good
one.
Using
Ume-‐weighted,
incremental
cash
flows,
this
project
provides
a
return
of
12.60%.
This
is
greater
than
the
cost
of
capital
of
8.46%.
¨ The
IRR
and
the
NPV
will
yield
similar
results
most
of
the
Ume,
though
there
are
differences
between
the
two
approaches
that
may
cause
project
rankings
to
vary
depending
upon
the
approach
used.
They
can
yield
different
results,
especially
why
comparing
across
projects
because
¤ A
project
can
have
only
one
NPV,
whereas
it
can
have
more
than
one
IRR.
¤ The
NPV
is
a
dollar
surplus
value,
whereas
the
IRR
is
a
percentage
measure
of
return.
The
NPV
is
therefore
likely
to
be
larger
for
“large
scale”
projects,
while
the
IRR
is
higher
for
“small-‐scale”
projects.
¤ The
NPV
assumes
that
intermediate
cash
flows
get
reinvested
at
the
“hurdle
rate”,
which
is
based
upon
what
you
can
make
on
investments
of
comparable
risk,
while
the
IRR
assumes
that
intermediate
cash
flows
get
reinvested
at
the
“IRR”.
Aswath Damodaran
237
Does
the
currency
maOer?
Aswath Damodaran
238
The
‘‘Consistency
Rule”
for
Cash
Flows
239
¨ The
cash
flows
on
a
project
and
the
discount
rate
used
should
be
defined
in
the
same
terms.
¤ If
cash
flows
are
in
dollars
($R),
the
discount
rate
has
to
be
a
dollar
($R)
discount
rate
¤ If
the
cash
flows
are
nominal
(real),
the
discount
rate
has
to
be
nominal
(real).
¨ If
consistency
is
maintained,
the
project
conclusions
should
be
idenUcal,
no
maOer
what
cash
flows
are
used.
Aswath
Damodaran
239
Disney
Theme
Park:
Project
Analysis
in
$R
240
¨ The
inflaUon
rates
were
assumed
to
be
9%
in
Brazil
and
2%
in
the
United
States.
The
$R/dollar
rate
at
the
Ume
of
the
analysis
was
2.35
$R/dollar.
¨ The
expected
exchange
rate
was
derived
assuming
purchasing
power
parity.
¤ Expected
Exchange
Ratet
=
Exchange
Rate
today
*
(1.09/1.02)t
¨ The
expected
growth
rate
a^er
year
10
is
sUll
expected
to
be
the
inflaUon
rate,
but
it
is
the
9%
$R
inflaUon
rate.
¨ The
cost
of
capital
in
$R
was
derived
from
the
cost
of
capital
in
dollars
and
the
differences
in
inflaUon
rates:
$R
Cost
of
Capital
=
(1+ Exp InflationBrazil )
(1+ US $ Cost of Capital) −1
(1+ Exp InflationUS )
¨ Based
on
our
expected
cash
flows
and
the
esUmated
cost
of
capital,
the
proposed
theme
park
looks
like
a
very
good
investment
for
Disney.
Which
of
the
following
may
affect
your
assessment
of
value?
¤ Revenues
may
be
over
esUmated
(crowds
may
be
smaller
and
spend
less)
¤ Actual
costs
may
be
higher
than
esUmated
costs
¤ Tax
rates
may
go
up
¤ Interest
rates
may
rise
¤ Risk
premiums
and
default
spreads
may
increase
¤ All
of
the
above
¨ How
would
you
respond
to
this
uncertainty?
¤ Will
wait
for
the
uncertainty
to
be
resolved
¤ Will
not
take
the
investment
¤ Ask
someone
else
(consultant,
boss,
colleague)
to
make
the
decision
¤ Ignore
it.
¤ Other
Aswath
Damodaran
242
One
simplisUc
soluUon:
See
how
quickly
you
can
get
your
money
back…
¨ If
your
biggest
fear
is
losing
the
billions
that
you
invested
in
the
project,
one
simple
measure
that
you
can
compute
is
the
number
of
years
it
will
take
you
to
get
your
money
back.
Year Cash Flow Cumulated CF PV of Cash Flow Cumulated DCF
0 -$2,000 -$2,000 -$2,000 -$2,000
1 -$1,000 -$3,000 -$922 -$2,922
2 -$859 -$3,859 -$730 -$3,652
3 -$267 -$4,126 -$210 -$3,862
4 $340 -$3,786 $246 -$3,616
5 $466 -$3,320 $311 -$3,305
6 $516 -$2,803 $317 -$2,988
7 $555 -$2,248 $314 -$2,674
8 $615 -$1,633 $321 -$2,353
9 $681 -$952 $328 -$2,025
Payback = 10.3 years 10 $715 -$237 $317 -$1,708
11 $729 $491 $298 -$1,409
12 $743 $1,235 $280 -$1,129
13 $758 $1,993 $264 -$865
14 $773 $2,766 $248 -$617 Discounted Payback
15 $789 $3,555 $233 -$384 = 16.8 years
16 $805 $4,360 $219 -$165
Aswath Damodaran 17 $821 $5,181 $206 $41 243
A
slightly
more
sophisUcated
approach:
SensiUvity
Analysis
&
What-‐if
QuesUons…
¨ The
NPV,
IRR
and
accounUng
returns
for
an
investment
will
change
as
we
change
the
values
that
we
use
for
different
variables.
¨ One
way
of
analyzing
uncertainty
is
to
check
to
see
how
sensiUve
the
decision
measure
(NPV,
IRR..)
is
to
changes
in
key
assumpUons.
While
this
has
become
easier
and
easier
to
do
over
Ume,
there
are
caveats
that
we
would
offer.
¨ Caveat
1:
When
analyzing
the
effects
of
changing
a
variable,
we
o^en
hold
all
else
constant.
In
the
real
world,
variables
move
together.
¨ Caveat
2:
The
objecUve
in
sensiUvity
analysis
is
that
we
make
beOer
decisions,
not
churn
out
more
tables
and
numbers.
¤ Corollary
1:
Less
is
more.
Not
everything
is
worth
varying…
¤ Corollary
2:
A
picture
is
worth
a
thousand
numbers
(and
tables).
Aswath Damodaran
244
And
here
is
a
really
good
picture…
Aswath Damodaran
245
The
final
step
up:
Incorporate
probabilisUc
esUmates..
Rather
than
expected
values..
Actual Revenues as % of Forecasted Revenues (Base case = 100%)
!
Operating Expenses at Parks as % of
Revenues (Base Case = 60%)
Aswath Damodaran
246
The
resulUng
simulaUon…
Average = $3.40 billion
Median = $3.28 billion
!
NPV ranges from -$1 billion to +$8.5 billion. NPV is negative 12% of the
time.
Aswath Damodaran
247
You
are
the
decision
maker…
248
¨ Assume
that
you
are
the
person
at
Disney
who
is
given
the
results
of
the
simulaUon.
The
average
and
median
NPV
are
close
to
your
base
case
values
of
$3.29
billion.
However,
there
is
a
10%
probability
that
the
project
could
have
a
negaUve
NPV
and
that
the
NPV
could
be
a
large
negaUve
value?
How
would
you
use
this
informaUon?
¤ I
would
accept
the
investment
and
print
the
results
of
this
simulaUon
and
file
them
away
to
show
that
I
exercised
due
diligence.
¤ I
would
reject
the
investment,
because
it
is
too
risky
(there
is
a
10%
chance
that
it
could
be
a
bad
project)
¤ Other
Aswath
Damodaran
248
Equity
Analysis:
The
Parallels
249
¨ The
investment
analysis
can
be
done
enUrely
in
equity
terms,
as
well.
The
returns,
cashflows
and
hurdle
rates
will
all
be
defined
from
the
perspecUve
of
equity
investors.
¨ If
using
accounUng
returns,
¤ Return
will
be
Return
on
Equity
(ROE)
=
Net
Income/BV
of
Equity
¤ ROE
has
to
be
greater
than
cost
of
equity
Aswath
Damodaran
249
A
Vale
Iron
Ore
Mine
in
Canada
Investment
OperaUng
AssumpUons
250
1. The
mine
will
require
an
iniUal
investment
of
$1.25
billion
and
is
expected
to
have
a
producUon
capacity
of
8
million
tons
of
iron
ore,
once
established.
The
iniUal
investment
of
$1.25
billion
will
be
depreciated
over
ten
years,
using
double
declining
balance
depreciaUon,
down
to
a
salvage
value
of
$250
million
at
the
end
of
ten
years.
2. The
mine
will
start
producUon
midway
through
the
next
year,
producing
4
million
tons
of
iron
ore
for
year
1,
with
producUon
increasing
to
6
million
tons
in
year
2
and
leveling
off
at
8
million
tons
therea^er
(unUl
year
10).
The
price,
in
US
dollars
per
ton
of
iron
ore
is
currently
$100
and
is
expected
to
keep
pace
with
inflaUon
for
the
life
of
the
plant.
3. The
variable
cost
of
producUon,
including
labor,
material
and
operaUng
expenses,
is
expected
to
be
$45/ton
of
iron
ore
produced
and
there
is
a
fixed
cost
of
$125
million
in
year
1.
Both
costs,
which
will
grow
at
the
inflaUon
rate
of
2%
therea^er.
The
costs
will
be
in
Canadian
dollars,
but
the
expected
values
are
converted
into
US
dollars,
assuming
that
the
current
parity
between
the
currencies
(1
Canadian
$
=
1
US
dollar)
will
conUnue,
since
interest
and
inflaUon
rates
are
similar
in
the
two
currencies.
4. The
working
capital
requirements
are
esUmated
to
be
20%
of
total
revenues,
and
the
investments
have
to
be
made
at
the
beginning
of
each
year.
At
the
end
of
the
tenth
year,
it
is
anUcipated
that
the
enUre
working
capital
will
be
salvaged.
5. Vale’s
corporate
tax
rate
of
34%
will
apply
to
this
project
as
well.
Aswath
Damodaran
250
Financing
AssumpUons
251
Vale
plans
to
borrow
$0.5
billion
at
its
current
cost
of
debt
of
4.05%
(based
upon
its
raUng
of
A-‐),
using
a
ten-‐year
term
loan
(where
the
loan
will
be
paid
off
in
equal
annual
increments).
The
breakdown
of
the
payments
each
year
into
interest
and
principal
are
provided
below:
Aswath
Damodaran
251
The
Hurdle
Rate
252
¨ The
analysis
is
done
US
dollar
terms
and
to
equity
investors.
Thus,
the
hurdle
rate
has
to
be
a
US
$
cost
of
equity.
¨ In
the
earlier
secUon,
we
esUmated
costs
of
equity,
debt
and
capital
in
US
dollars
and
$R
for
Vale’s
iron
ore
business.
Cost of After-tax cost of Debt Cost of capital (in Cost of capital (in
Business equity debt ratio US$) $R)
Metals &
Mining 11.35% 2.67% 35.48% 8.27% 15.70%
Iron Ore 11.13% 2.67% 35.48% 8.13% 15.55%
Fertilizers 12.70% 2.67% 35.48% 9.14% 16.63%
Logistics 10.29% 2.67% 35.48% 7.59% 14.97%
Vale Operations 11.23% 2.67% 35.48% 8.20% 15.62%
Aswath
Damodaran
252
Net
Income:
Vale
Iron
Ore
Mine
253
1 2 3 4 5 6 7 8 9 10
Production (millions of tons) 4.00 6.00 8.00 8.00 8.00 8.00 8.00 8.00 8.00 8.00
* Price per ton 102 104.04 106.12 108.24 110.41 112.62 114.87 117.17 119.51 121.9
= Revenues (millions US$) $408.00 $624.24 $848.97 $865.95 $883.26 $900.93 $918.95 $937.33 $956.07 $975.20
- Variable Costs $180.00 $275.40 $374.54 $382.03 $389.68 $397.47 $405.42 $413.53 $421.80 $430.23
- Fixed Costs $125.00 $127.50 $130.05 $132.65 $135.30 $138.01 $140.77 $143.59 $146.46 $149.39
- Depreciation $200.00 $160.00 $128.00 $102.40 $81.92 $65.54 $65.54 $65.54 $65.54 $65.54
EBIT -$97.00 $61.34 $216.37 $248.86 $276.37 $299.91 $307.22 $314.68 $322.28 $330.04
- Interest Expenses $20.25 $18.57 $16.82 $14.99 $13.10 $11.13 $9.07 $6.94 $4.72 $2.41
Taxable Income -$117.25 $42.77 $199.56 $233.87 $263.27 $288.79 $298.15 $307.74 $317.57 $327.63
- Taxes ($39.87) $14.54 $67.85 $79.51 $89.51 $98.19 $101.37 $104.63 $107.97 $111.40
= Net Income (millions US$) -$77.39 $28.23 $131.71 $154.35 $173.76 $190.60 $196.78 $203.11 $209.59 $216.24
Book Value and Depreciation
Beg. Book Value $1,250.00 $1,050.00 $890.00 $762.00 $659.60 $577.68 $512.14 $446.61 $381.07 $315.54
- Depreciation $200.00 $160.00 $128.00 $102.40 $81.92 $65.54 $65.54 $65.54 $65.54 $65.54
+ Capital Exp. $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00
End Book Value $1,050.00 $890.00 $762.00 $659.60 $577.68 $512.14 $446.61 $381.07 $315.54 $250.00
- Debt Outstanding $458.45 $415.22 $370.24 $323.43 $274.73 $224.06 $171.34 $116.48 $59.39 $0.00
End Book Value of Equity $591.55 $474.78 $391.76 $336.17 $302.95 $288.08 $275.27 $264.60 $256.14 $250.00
Aswath
Damodaran
253
A
ROE
Analysis
254
BV of
Beg. BV: Capital Ending BV: Average BV:
Year Net Income Depreciation Working Debt BV: Equity ROE
Assets Expense Assets Equity
Capital
0 $0.00 $0.00 $1,250.00 $1,250.00 $81.60 $500.00 $831.60
1 ($77.39) $1,250.00 $200.00 $0.00 $1,050.00 $124.85 $458.45 $716.40 $774.00 -10.00%
2 $28.23 $1,050.00 $160.00 $0.00 $890.00 $169.79 $415.22 $644.57 $680.49 4.15%
3 $131.71 $890.00 $128.00 $0.00 $762.00 $173.19 $370.24 $564.95 $604.76 21.78%
4 $154.35 $762.00 $102.40 $0.00 $659.60 $176.65 $323.43 $512.82 $538.89 28.64%
5 $173.76 $659.60 $81.92 $0.00 $577.68 $180.19 $274.73 $483.13 $497.98 34.89%
6 $190.60 $577.68 $65.54 $0.00 $512.14 $183.79 $224.06 $471.87 $477.50 39.92%
7 $196.78 $512.14 $65.54 $0.00 $446.61 $187.47 $171.34 $462.74 $467.31 42.11%
8 $203.11 $446.61 $65.54 $0.00 $381.07 $191.21 $116.48 $455.81 $459.27 44.22%
9 $209.59 $381.07 $65.54 $0.00 $315.54 $195.04 $59.39 $451.18 $453.50 46.22%
10 $216.24 $315.54 $65.54 $0.00 $250.00 $0.00 $0.00 $250.00 $350.59 61.68%
Average ROE over the ten-year period = 31.36%
Aswath
Damodaran
254
From
Project
ROE
to
Firm
ROE
255
¨ As
with
the
earlier
analysis,
where
we
used
return
on
capital
and
cost
of
capital
to
measure
the
overall
quality
of
projects
at
firms,
we
can
compute
return
on
equity
and
cost
of
equity
to
pass
judgment
on
whether
firms
are
creaUng
value
to
its
equity
investors.
¨ Specifically,
we
can
compute
the
return
on
equity
(net
income
as
a
percentage
of
book
equity)
and
compare
to
the
cost
of
equity.
The
return
spread
is
then:
¨ Equity
Return
Spread
=
Return
on
Equity
–
Cost
of
equity
¨ This
measure
is
parUcularly
useful
for
financial
service
firms,
where
capital,
return
on
capital
and
cost
of
capital
are
difficult
measures
to
nail
down.
¨ For
non-‐financial
service
firms,
it
provides
a
secondary
(albeit
a
more
volaUle
measure
of
performance).
While
it
usually
provides
the
same
general
result
that
the
excess
return
computed
from
return
on
capital,
there
can
be
cases
where
the
two
measures
diverge.
Aswath
Damodaran
255
An
Incremental
CF
Analysis
256
0 1 2 3 4 5 6 7 8 9 10
Net Income ($77.39) $28.23 $131.71 $154.35 $173.76 $190.60 $196.78 $203.11 $209.59 $216.24
+ Depreciation & Amortization $200.00 $160.00 $128.00 $102.40 $81.92 $65.54 $65.54 $65.54 $65.54 $65.54
- Capital Expenditures $750.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00 $0.00
- Change in Working Capital $81.60 $43.25 $44.95 $3.40 $3.46 $3.53 $3.60 $3.68 $3.75 $3.82 ($195.04)
- Principal Repayments $41.55 $43.23 $44.98 $46.80 $48.70 $50.67 $52.72 $54.86 $57.08 $59.39
+ Salvage Value of mine $250.00
Cashflow to Equity ($831.60) $37.82 $100.05 $211.33 $206.48 $203.44 $201.86 $205.91 $210.04 $214.22 $667.42
Aswath
Damodaran
256
An
Equity
NPV
Discounted at US$ cost of
equity of 11.13% for Vale’s
iron ore business
257
Aswath
Damodaran
257
An
Equity
IRR
258
Aswath
Damodaran
258
Real
versus
Nominal
Analysis
259
¨ No
¨ Explain
Aswath
Damodaran
259
Dealing
with
Macro
Uncertainty:
The
Effect
of
Iron
Ore
Price
260
¨ Like
the
Disney
Theme
Park,
the
Vale
Iron
Ore
Mine’s
actual
value
will
be
buffeted
as
the
variables
change.
The
biggest
source
of
variability
is
an
external
factor
–the
price
of
iron
ore.
Vale Paper Plant: Effect of Changing Iron Ore Prices
$1,500 40.00%
30.00%
$1,000
20.00%
$500
10.00%
NPV
NP
$0 0.00%
$50 $60 $70 $80 $90 $100 $110 $120 $130
-10.00%
-$500
-20.00%
-$1,000
-30.00%
$600
20.00%
$500
$400
15.00%
$300
NPV
10.00%
IRR
$200
$100
5.00%
$0
-‐$100 0.00%
Aswath
Damodaran
261
Should
you
hedge?
262
¨ The
value
of
this
mine
is
very
much
a
funcUon
iron
ore
prices.
There
are
futures,
forward
and
opUon
markets
iron
ore
that
Vale
can
use
to
hedge
against
price
movements.
Should
it?
¤ Yes
¤ No
Explain.
¨ The
value
of
the
mine
is
also
a
funcUon
of
exchange
rates.
There
are
forward,
futures
and
opUons
markets
on
currency.
Should
Vale
hedge
against
exchange
rate
risk?
¤ Yes
¤ No
Explain.
¨ On
the
last
quesUon,
would
your
answer
have
been
different
if
the
mine
were
in
Brazil.
¤ Yes
¤ No
Aswath
Damodaran
262
Value Trade Off
What is the cost to the firm of hedging this risk? Cash flow benefits
- Tax benefits
- Better project choices
Negligible High
Hedge this risk. The Indifferent to Can marginal investors Do not hedge this risk.
benefits to the firm will hedging risk hedge this risk cheaper The benefits are small
exceed the costs than the firm can? relative to costs
Pricing Trade
Earnings Multiple Earnings
- Effect on multiple X - Level
Yes No
- Volatility
Will the benefits persist if investors hedge Hedge this risk. The
the risk instead of the firm? benefits to the firm will
exceed the costs
Yes No
¨ An
acquisiUon
is
an
investment/project
like
any
other
and
all
of
the
rules
that
apply
to
tradiUonal
investments
should
apply
to
acquisiUons
as
well.
In
other
words,
for
an
acquisiUon
to
make
sense:
¤ It
should
have
posiUve
NPV.
The
present
value
of
the
expected
cash
flows
from
the
acquisiUon
should
exceed
the
price
paid
on
the
acquisiUon.
¤ The
IRR
of
the
cash
flows
to
the
firm
(equity)
from
the
acquisiUon
>
Cost
of
capital
(equity)
on
the
acquisiUon
¨ In
esUmaUng
the
cash
flows
on
the
acquisiUon,
we
should
count
in
any
possible
cash
flows
from
synergy.
¨ The
discount
rate
to
assess
the
present
value
should
be
based
upon
the
risk
of
the
investment
(target
company)
and
not
the
enUty
considering
the
investment
(acquiring
company).
Aswath
Damodaran
264
Tata
Motors
and
Harman
InternaUonal
265
with
an
eye
on
using
its
audio
equipment
in
its
Indian
automobiles,
as
opUonal
upgrades
on
new
cars.
Aswath
Damodaran
265
EsUmaUng
the
Cost
of
Capital
for
the
AcquisiUon
(no
synergy)
266
1. Currency:
EsUmated
in
US
$,
since
cash
flows
will
be
esUmated
in
US
$.
2. Beta:
Harman
InternaUonal
is
an
electronic
company
and
we
use
the
unlevered
beta
(1.17)
of
electronics
companies
in
the
US.
3. Equity
Risk
Premium:
Computed
based
on
Harman’s
operaUng
exposure:
4. Debt
raUo
&
cost
of
debt:
Tata
Motors
plans
to
assume
the
exisUng
debt
of
Harman
InternaUonal
and
to
preserve
Harman’s
exisUng
debt
raUo.
Harman
currently
has
a
debt
(including
lease
commitments)
to
capital
raUo
of
7.39%
(translaUng
into
a
debt
to
equity
raUo
of
7.98%)
and
faces
a
pre-‐tax
cost
of
debt
of
4.75%
(based
on
its
BBB-‐
raUng).
Levered
Beta
=
1.17
(1+
(1-‐.40)
(.0798))
=
1.226
Cost
of
Equity=
2.75%
+
1.226
(6.13%)
=
10.26%
Cost
of
Capital
=
10.26%
(1-‐.0739)
+
4.75%
(1-‐.40)
(.0739)
=
9.67%
Aswath
Damodaran
266
EsUmaUng
Cashflows-‐
First
Steps
267
¨ We
will
assume
that
Harman
InternaUonal
is
a
mature
firm,
growing
2.75%
in
perpetuity.
¨ We
assume
that
revenues,
operaUng
income,
capital
expenditures
and
depreciaUon
will
all
grow
2.75%
for
the
year
and
that
the
non-‐cash
working
capital
remain
13.54%
of
revenues
in
future
periods.
Aswath
Damodaran
268
Value
of
Harman
InternaUonal:
Before
Synergy
269
¨ Earlier,
we
esUmated
the
cost
of
capital
of
9.67%
as
the
right
discount
rate
to
apply
in
valuing
Harman
InternaUonal
and
the
cash
flow
to
the
firm
of
$166.85
million
for
2014
(next
year),
assuming
a
2.75%
growth
rate
in
revenues,
operaUng
income,
depreciaUon,
capital
expenditures
and
total
non-‐cash
working
capital.
We
also
assumed
that
these
cash
flows
would
conUnue
to
grow
2.75%
a
year
in
perpetuity.
¨ Adding
the
cash
balance
of
the
firm
($515
million)
and
subtracUng
out
the
exisUng
debt
($313
million,
including
the
debt
value
of
leases)
yields
the
value
of
equity
in
the
firm:
¨ Value
of
Equity
=
Value
of
OperaUng
Assets
+
Cash
–
Debt
=
$2,476
+
$
515
-‐
$313
million
=
$2,678
million
¨ The
market
value
of
equity
in
Harman
in
November
2013
was
$5,428
million.
¨ To
the
extent
that
Tata
Motors
pays
the
market
price,
it
will
have
to
generate
benefits
from
synergy
that
exceed
$2750
million.
Aswath
Damodaran
269
Aswath
Damodaran
270
¨ In
all
of
the
examples
we
have
used
so
far,
the
investments
that
we
have
analyzed
have
stood
alone.
Thus,
our
job
was
a
simple
one.
Assess
the
expected
cash
flows
on
the
investment
and
discount
them
at
the
right
discount
rate.
¨ In
the
real
world,
most
investments
are
not
independent.
Taking
an
investment
can
o^en
mean
rejecUng
another
investment
at
one
extreme
(mutually
exclusive)
to
being
locked
in
to
take
an
investment
in
the
future
(pre-‐requisite).
¨ More
generally,
accepUng
an
investment
can
create
side
costs
for
a
firm’s
exisUng
investments
in
some
cases
and
benefits
for
others.
Aswath
Damodaran
271
I.
Mutually
Exclusive
Investments
272
Aswath
Damodaran
273
Case
1:
IRR
versus
NPV
274
Aswath
Damodaran
274
Project’s
NPV
Profile
275
Aswath
Damodaran
275
What
do
we
do
now?
276
¨ Project
1
has
two
internal
rates
of
return.
The
first
is
6.60%,
whereas
the
second
is
36.55%.
Project
2
has
one
internal
rate
of
return,
about
12.8%.
¨ Why
are
there
two
internal
rates
of
return
on
project
1?
¨ If
your
cost
of
capital
is
12%,
which
investment
would
you
accept?
a. Project
1
b. Project
2
¨ Explain.
Aswath
Damodaran
276
Case
2:
NPV
versus
IRR
277
Project A
Investment $ 1,000,000
NPV = $467,937
IRR= 33.66%
Project B
Investment $ 10,000,000
NPV = $1,358,664
IRR=20.88%
Aswath
Damodaran
277
Which
one
would
you
pick?
278
¨ Assume
that
you
can
pick
only
one
of
these
two
projects.
Your
choice
will
clearly
vary
depending
upon
whether
you
look
at
NPV
or
IRR.
You
have
enough
money
currently
on
hand
to
take
either.
Which
one
would
you
pick?
a. Project
A.
It
gives
me
the
bigger
bang
for
the
buck
and
more
margin
for
error.
b. Project
B.
It
creates
more
dollar
value
in
my
business.
¨ If
you
pick
A,
what
would
your
biggest
concern
be?
¨ If you pick B, what would your biggest concern be?
Aswath
Damodaran
278
Capital
RaUoning,
Uncertainty
and
Choosing
a
Rule
279
Aswath
Damodaran
279
The
sources
of
capital
raUoning…
280
Aswath
Damodaran
280
An
AlternaUve
to
IRR
with
Capital
RaUoning
281
¨ The
problem
with
the
NPV
rule,
when
there
is
capital
raUoning,
is
that
it
is
a
dollar
value.
It
measures
success
in
absolute
terms.
¨ The
NPV
can
be
converted
into
a
relaUve
measure
by
dividing
by
the
iniUal
investment.
This
is
called
the
profitability
index.
¤ Profitability
Index
(PI)
=
NPV/IniUal
Investment
¨ In
the
example
described,
the
PI
of
the
two
projects
would
have
been:
¤ PI
of
Project
A
=
$467,937/1,000,000
=
46.79%
¤ PI
of
Project
B
=
$1,358,664/10,000,000
=
13.59%
¤ Project
A
would
have
scored
higher.
Aswath
Damodaran
281
Case
3:
NPV
versus
IRR
282
Project A
Investment $ 10,000,000
NPV = $1,191,712
IRR=21.41%
Project B
Investment $ 10,000,000
NPV = $1,358,664
IRR=20.88%
Aswath
Damodaran
282
Why
the
difference?
283
¨ These
projects
are
of
the
same
scale.
Both
the
NPV
and
IRR
use
Ume-‐weighted
cash
flows.
Yet,
the
rankings
are
different.
Why?
Aswath
Damodaran
283
NPV,
IRR
and
the
Reinvestment
Rate
AssumpUon
284
¨ The
NPV
rule
assumes
that
intermediate
cash
flows
on
the
project
get
reinvested
at
the
hurdle
rate
(which
is
based
upon
what
projects
of
comparable
risk
should
earn).
¨ The
IRR
rule
assumes
that
intermediate
cash
flows
on
the
project
get
reinvested
at
the
IRR.
Implicit
is
the
assumpUon
that
the
firm
has
an
infinite
stream
of
projects
yielding
similar
IRRs.
¨ Conclusion:
When
the
IRR
is
high
(the
project
is
crea?ng
significant
surplus
value)
and
the
project
life
is
long,
the
IRR
will
overstate
the
true
return
on
the
project.
Aswath
Damodaran
284
SoluUon
to
Reinvestment
Rate
Problem
285
Aswath
Damodaran
285
Why
NPV
and
IRR
may
differ..
Even
if
projects
have
the
same
lives
286
¨ A
project
can
have
only
one
NPV,
whereas
it
can
have
more
than
one
IRR.
¨ The
NPV
is
a
dollar
surplus
value,
whereas
the
IRR
is
a
percentage
measure
of
return.
The
NPV
is
therefore
likely
to
be
larger
for
“large
scale”
projects,
while
the
IRR
is
higher
for
“small-‐scale”
projects.
¨ The
NPV
assumes
that
intermediate
cash
flows
get
reinvested
at
the
“hurdle
rate”,
which
is
based
upon
what
you
can
make
on
investments
of
comparable
risk,
while
the
IRR
assumes
that
intermediate
cash
flows
get
reinvested
at
the
“IRR”.
Aswath
Damodaran
286
Comparing
projects
with
different
lives..
287
Project A
-$1000
NPV of Project A = $ 442
IRR of Project A = 28.7%
Project B
$350 $350 $350 $350 $350 $350 $350 $350 $350 $350
Aswath
Damodaran
287
Why
NPVs
cannot
be
compared..
When
projects
have
different
lives.
288
¨ The
IRR
is
unaffected
by
project
life.
We
can
choose
the
project
with
the
higher
IRR.
Aswath
Damodaran
288
SoluUon
1:
Project
ReplicaUon
289
Project A: Replicated
$400 $400 $400 $400 $400 $400 $400 $400 $400 $400
Project B
$350 $350 $350 $350 $350 $350 $350 $350 $350 $350
-$1500
NPV of Project B= $ 478
Aswath
Damodaran
289
SoluUon
2:
Equivalent
AnnuiUes
290
¤ = $ 122.62
¤ = $ 84.60
Aswath
Damodaran
290
What
would
you
choose
as
your
investment
tool?
291
Decision
Rule
%
of
Firms
using
as
primary
decision
rule
in
1976
1986
1998
IRR
53.6%
49.0%
42.0%
AccounUng
Return
25.0%
8.0%
7.0%
NPV
9.8%
21.0%
34.0%
Payback
Period
8.9%
19.0%
14.0%
Profitability
Index
2.7%
3.0%
3.0%
Aswath
Damodaran
292
II.
Side
Costs
and
Benefits
293
Aswath
Damodaran
293
A.
Opportunity
Cost
294
Aswath
Damodaran
294
Case
1:
Foregone
Sale?
295
¨ Assume
that
Disney
owns
land
in
Rio
already.
This
land
is
undeveloped
and
was
acquired
several
years
ago
for
$
5
million
for
a
hotel
that
was
never
built.
It
is
anUcipated,
if
this
theme
park
is
built,
that
this
land
will
be
used
to
build
the
offices
for
Disney
Rio.
The
land
currently
can
be
sold
for
$
40
million,
though
that
would
create
a
capital
gain
(which
will
be
taxed
at
20%).
In
assessing
the
theme
park,
which
of
the
following
would
you
do:
¤ Ignore
the
cost
of
the
land,
since
Disney
owns
its
already
¤ Use
the
book
value
of
the
land,
which
is
$
5
million
¤ Use
the
market
value
of
the
land,
which
is
$
40
million
¤ Other:
Aswath
Damodaran
295
Case
2:
Incremental
Cost?
An
Online
Retailing
Venture
for
Bookscape
296
¨ The
iniUal
investment
needed
to
start
the
service,
including
the
installaUon
of
addiUonal
phone
lines
and
computer
equipment,
will
be
$1
million.
These
investments
are
expected
to
have
a
life
of
four
years,
at
which
point
they
will
have
no
salvage
value.
The
investments
will
be
depreciated
straight
line
over
the
four-‐year
life.
¨ The
revenues
in
the
first
year
are
expected
to
be
$1.5
million,
growing
20%
in
year
two,
and
10%
in
the
two
years
following.
The
cost
of
the
books
will
be
60%
of
the
revenues
in
each
of
the
four
years.
¨ The
salaries
and
other
benefits
for
the
employees
are
esUmated
to
be
$150,000
in
year
one,
and
grow
10%
a
year
for
the
following
three
years.
¨ The
working
capital,
which
includes
the
inventory
of
books
needed
for
the
service
and
the
accounts
receivable
will
be10%
of
the
revenues;
the
investments
in
working
capital
have
to
be
made
at
the
beginning
of
each
year.
At
the
end
of
year
4,
the
enUre
working
capital
is
assumed
to
be
salvaged.
¨ The
tax
rate
on
income
is
expected
to
be
40%.
Aswath
Damodaran
296
Cost
of
capital
for
investment
297
¨ We
will
re-‐esUmate
the
beta
for
this
online
project
by
looking
at
publicly
traded
online
retailers.
The
unlevered
total
beta
of
online
retailers
is
3.02,
and
we
assume
that
this
project
will
be
funded
with
the
same
mix
of
debt
and
equity
(D/E
=
21.41%,
Debt/Capital
=
17.63%)
that
Bookscape
uses
in
the
rest
of
the
business.
We
will
assume
that
Bookscape’s
tax
rate
(40%)
and
pretax
cost
of
debt
(4.05%)
apply
to
this
project.
Levered
Beta
Online
Service
=
3.02
[1
+
(1
–
0.4)
(0.2141)]
=
3.41
Cost
of
Equity
Online
Service
=
2.75%
+
3.41
(5.5%)
=
21.48%
Cost
of
CapitalOnline
Service=
21.48%
(0.8237)
+
4.05%
(1
–
0.4)
(0.1763)
=
18.12%
¨ This
is
much
higher
than
the
cost
of
capital
(10.30%)
we
computed
for
Bookscape
earlier,
but
it
reflects
the
higher
risk
of
the
online
retail
venture.
Aswath
Damodaran
297
Incremental
Cash
flows
on
Investment
298
0 1 2 3 4
Revenues $1,500,000 $1,800,000 $1,980,000 $2,178,000
Operating Expenses
Labor $150,000 $165,000 $181,500 $199,650
Materials $900,000 $1,080,000 $1,188,000 $1,306,800
Depreciation $250,000 $250,000 $250,000 $250,000
Operating Income $200,000 $305,000 $360,500 $421,550
Taxes $80,000 $122,000 $144,200 $168,620
After-tax Operating
Income $120,000 $183,000 $216,300 $252,930
+ Depreciation $250,000 $250,000 $250,000 $250,000
- Change in Working
Capital $150,000 $30,000 $18,000 $19,800 -$217,800
+ Salvage Value of
Investment $0
Cash flow after taxes -$1,150,000 $340,000 $415,000 $446,500 $720,730
Present Value -$1,150,000 $287,836 $297,428 $270,908 $370,203
¨ In
the
Vale
example,
assume
that
the
firm
will
use
its
exisUng
distribuUon
system
to
service
the
producUon
out
of
the
new
iron
ore
mine.
The
mine
manager
argues
that
there
is
no
cost
associated
with
using
this
system,
since
it
has
been
paid
for
already
and
cannot
be
sold
or
leased
to
a
compeUtor
(and
thus
has
no
compeUng
current
use).
Do
you
agree?
a. Yes
b. No
Aswath
Damodaran
301
A
Framework
for
Assessing
The
Cost
of
Using
Excess
Capacity
302
¨ If
I
do
not
add
the
new
product,
when
will
I
run
out
of
capacity?
¨ If
I
add
the
new
product,
when
will
I
run
out
of
capacity?
¨ When
I
run
out
of
capacity,
what
will
I
do?
¤ Cut
back
on
producUon:
cost
is
PV
of
a^er-‐tax
cash
flows
from
lost
sales
¤ Buy
new
capacity:
cost
is
difference
in
PV
between
earlier
&
later
investment
Aswath
Damodaran
302
Product
and
Project
CannibalizaUon:
A
Real
Cost?
303
¨ Assume
that
in
the
Disney
theme
park
example,
20%
of
the
revenues
at
the
Rio
Disney
park
are
expected
to
come
from
people
who
would
have
gone
to
Disney
theme
parks
in
the
US.
In
doing
the
analysis
of
the
park,
you
would
a. Look
at
only
incremental
revenues
(i.e.
80%
of
the
total
revenue)
b. Look
at
total
revenues
at
the
park
c. Choose
an
intermediate
number
¨ Would
your
answer
be
different
if
you
were
analyzing
whether
to
introduce
a
new
show
on
the
Disney
cable
channel
on
Saturday
mornings
that
is
expected
to
aOract
20%
of
its
viewers
from
ABC
(which
is
also
owned
by
Disney)?
a. Yes
b. No
Aswath
Damodaran
303
B.
Project
Synergies
304
¨ A
project
may
provide
benefits
for
other
projects
within
the
firm.
Consider,
for
instance,
a
typical
Disney
animated
movie.
Assume
that
it
costs
$
50
million
to
produce
and
promote.
This
movie,
in
addiUon
to
theatrical
revenues,
also
produces
revenues
from
¤ the
sale
of
merchandise
(stuffed
toys,
plasUc
figures,
clothes
..)
¤ increased
aOendance
at
the
theme
parks
¤ stage
shows
(see
“Beauty
and
the
Beast”
and
the
“Lion
King”)
¤ television
series
based
upon
the
movie
¨ In
investment
analysis,
however,
these
synergies
are
either
le^
unquanUfied
and
used
to
jusUfy
overriding
the
results
of
investment
analysis,
i.e,,
used
as
jusUficaUon
for
invesUng
in
negaUve
NPV
projects.
¨ If
synergies
exist
and
they
o^en
do,
these
benefits
have
to
be
valued
and
shown
in
the
iniUal
project
analysis.
Aswath
Damodaran
304
Case
1:
Adding
a
Café
to
a
bookstore:
Bookscape
305
¨ Assume
that
you
are
considering
adding
a
café
to
the
bookstore.
Assume
also
that
based
upon
the
expected
revenues
and
expenses,
the
café
standing
alone
is
expected
to
have
a
net
present
value
of
-‐$87,571.
¨ The
cafe
will
increase
revenues
at
the
book
store
by
$500,000
in
year
1,
growing
at
10%
a
year
for
the
following
4
years.
In
addiUon,
assume
that
the
pre-‐tax
operaUng
margin
on
these
sales
is
10%.
1 2 3 4 5
Increased Revenues $500,000 $550,000 $605,000 $665,500 $732,050
Operating Margin 10.00% 10.00% 10.00% 10.00% 10.00%
Operating Income $50,000 $55,000 $60,500 $66,550 $73,205
Operating Income after Taxes $30,000 $33,000 $36,300 $39,930 $43,923
PV of Additional Cash Flows $27,199 $27,126 $27,053 $26,981 $26,908
PV of Synergy Benefits $135,268
¨ The
net
present
value
of
the
added
benefits
is
$135,268.
Added
to
the
NPV
of
the
standalone
Café
of
-‐$87,571
yields
a
net
present
value
of
$47,697.
Aswath
Damodaran
305
Case
2:
Synergy
in
a
merger..
306
¨ We
valued
Harman
InternaUonal
for
an
acquisiUon
by
Tata
Motors
and
esUmated
a
value
of
$
2,476
million
for
the
operaUng
assets
and
$
2,678
million
for
the
equity
in
the
firm,
concluding
that
it
would
not
be
a
value-‐
creaUng
acquisiUon
at
its
current
market
capitalizaUon
of
$5,248
million.
In
esUmaUng
this
value,
though,
we
treated
Harman
InternaUonal
as
a
stand-‐alone
firm.
¨ Assume
that
Tata
Motors
foresees
potenUal
synergies
in
the
combinaUon
of
the
two
firms,
primarily
from
using
its
using
Harman’s
high-‐end
audio
technology
(speakers,
tuners)
as
opUonal
upgrades
for
customers
buying
new
Tata
Motors
cars
in
India.
To
value
this
synergy,
let
us
assume
the
following:
¤ It
will
take
Tata
Motors
approximately
3
years
to
adapt
Harman’s
products
to
Tata
Motors
cars.
¤ Tata
Motors
will
be
able
to
generate
Rs
10
billion
in
a^er-‐tax
operaUng
income
in
year
4
from
selling
Harman
audio
upgrades
to
its
Indian
customers,
growing
at
a
rate
of
4%
a
year
a^er
that
in
perpetuity
(but
only
in
India).
Aswath
Damodaran
306
EsUmaUng
the
cost
of
capital
to
use
in
valuing
synergy..
307
¨ Business
risk:
The
perceived
synergies
flow
from
opUonal
add-‐ons
in
auto
sales.
We
will
begin
with
the
levered
beta
of
1.10,
that
we
esUmated
for
Tata
Motors
in
chapter
4,
in
esUmaUng
the
cost
of
equity.
¨ Geographic
risk:
The
second
is
that
the
synergies
are
expected
to
come
from
India;
consequently,
we
will
add
the
country
risk
premium
of
3.60%
for
India,
esUmated
in
chapter
4
(for
Tata
Motors)
to
the
mature
market
premium
of
5.5%.
¨ Debt
raUo:
Finally,
we
will
assume
that
the
expansion
will
be
enUrely
in
India,
with
Tata
Motors
maintain
its
exisUng
debt
to
capital
raUo
of
29.28%
and
its
current
rupee
cost
of
debt
of
9.6%
and
its
marginal
tax
rate
of
32.45%.
¤ Cost
of
equity
in
Rupees
=
6.57%
+
1.10
(5.5%+3.60%)
=
16.59%
¤ Cost
of
debt
in
Rupees
=
9.6%
(1-‐.3245)
=
6.50%
¤ Cost
of
capital
in
Rupees
=
16.59%
(1-‐.2928)
+
6.50%
(.2928)
=
13.63%
Aswath
Damodaran
307
EsUmaUng
the
value
of
synergy…
and
what
Tata
can
pay
for
Harman
308
¨ ConverUng
the
synergy
value
into
dollar
terms
at
the
prevailing
exchange
rate
of
Rs
60/$,
we
can
esUmate
a
dollar
value
for
the
synergy
from
the
potenUal
acquisiUon:
¤ Value
of
synergy
in
US
$
=
Rs
70,753/60
=
$
1,179
million
¨ Adding
this
value
to
the
intrinsic
value
of
$2,678
million
that
we
esUmated
for
Harman’s
equity
in
chapter
5,
we
get
a
total
value
for
the
equity
of
$3,857
million.
¤ Value
of
Harman
=
$2,678
million
+
$1,179
million
=
$3,857
million
¨ Since
Harman’s
equity
trades
at
$5,248
million,
the
acquisiUon
sUll
does
not
make
sense,
even
with
the
synergy
incorporated
into
value.
Aswath
Damodaran
308
III.
Project
OpUons
309
¨ When
a
firm
has
exclusive
rights
to
a
project
or
product
for
a
specific
period,
it
can
delay
taking
this
project
or
product
unUl
a
later
date.
A
tradiUonal
investment
analysis
just
answers
the
quesUon
of
whether
the
project
is
a
“good”
one
if
taken
today.
The
rights
to
a
“bad”
project
can
sUll
have
value.
PV of Cash Flows
Initial Investment in
Project NPV is positive in this section
Aswath
Damodaran
310
Insights
for
Investment
Analyses
311
¨ Having
the
exclusive
rights
to
a
product
or
project
is
valuable,
even
if
the
product
or
project
is
not
viable
today.
¨ The
value
of
these
rights
increases
with
the
volaUlity
Aswath
Damodaran
311
The
OpUon
to
Expand/Take
Other
Projects
312
¨ Taking
a
project
today
may
allow
a
firm
to
consider
and
take
other
valuable
projects
in
the
future.
Thus,
even
though
a
project
may
have
a
negaUve
NPV,
it
may
be
a
project
worth
taking
if
the
opUon
it
provides
the
firm
(to
take
other
projects
in
the
future)
has
a
more-‐than-‐
compensaUng
value.
PV of Cash Flows
from Expansion
Additional Investment
to Expand
Aswath
Damodaran
312
The
OpUon
to
Abandon
313
¨ A
firm
may
someUmes
have
the
opUon
to
abandon
a
project,
if
the
cash
flows
do
not
measure
up
to
expectaUons.
¨ If
abandoning
the
project
allows
the
firm
to
save
itself
from
further
losses,
this
opUon
can
make
a
project
more
valuable.
PV of Cash Flows
from Project
Cost of Abandonment
Aswath
Damodaran
313
IV.
Assessing
ExisUng
or
Past
investments…
314
¨ While
much
of
our
discussion
has
been
focused
on
analyzing
new
investments,
the
techniques
and
principles
enunciated
apply
just
as
strongly
to
exisUng
investments.
¨ With
exisUng
investments,
we
can
try
to
address
one
of
two
quesUons:
¤ Post
–mortem:
We
can
look
back
at
exisUng
investments
and
see
if
they
have
created
value
for
the
firm.
¤ What
next?
We
can
also
use
the
tools
of
investment
analysis
to
see
whether
we
should
keep,
expand
or
abandon
exisUng
investments.
Aswath
Damodaran
314
Analyzing
an
ExisUng
Investment
315
In a post-mortem, you look at the actual cash You can also reassess your expected cash
flows, relative to forecasts. flows, based upon what you have learned,
and decide whether you should expand,
continue or divest (abandon) an investment
Aswath
Damodaran
315
a.
Post
Mortem
Analysis
316
¨ The
actual
cash
flows
from
an
investment
can
be
greater
than
or
less
than
originally
forecast
for
a
number
of
reasons
but
all
these
reasons
can
be
categorized
into
two
groups:
¤ Chance:
The
nature
of
risk
is
that
actual
outcomes
can
be
different
from
expectaUons.
Even
when
forecasts
are
based
upon
the
best
of
informaUon,
they
will
invariably
be
wrong
in
hindsight
because
of
unexpected
shi^s
in
both
macro
(inflaUon,
interest
rates,
economic
growth)
and
micro
(compeUtors,
company)
variables.
¤ Bias:
If
the
original
forecasts
were
biased,
the
actual
numbers
will
be
different
from
expectaUons.
The
evidence
on
capital
budgeUng
is
that
managers
tend
to
be
over-‐
opUmisUc
about
cash
flows
and
the
bias
is
worse
with
over-‐confident
managers.
¨ While
it
is
impossible
to
tell
on
an
individual
project
whether
chance
or
bias
is
to
blame,
there
is
a
way
to
tell
across
projects
and
across
Ume.
If
chance
is
the
culprit,
there
should
be
symmetry
in
the
errors
–
actuals
should
be
about
as
likely
to
beat
forecasts
as
they
are
to
come
under
forecasts.
If
bias
is
the
reason,
the
errors
will
tend
to
be
in
one
direcUon.
Aswath
Damodaran
316
b.
What
should
we
do
next?
317
t =n
t =n
NFn
∑
n < Salvage
Value
........
Terminate
the
project
€ t =0 (1 + r)
€
t =n
t =n
NFn
∑
n > 0 >
Divestiture
Value
........
ConUnue
the
project
€ (1 + r)
t =0
Aswath
Damodaran
317
€
Example:
Disney
California
Adventure
–
The
2008
judgment
call
318
¨ Disney
opened
the
Disney
California
Adventure
(DCA)
Park
in
2001,
at
a
cost
of
$1.5
billion,
with
a
mix
of
roller
coaster
ridesand
movie
nostalgia.
Disney
expected
about
60%
of
its
visitors
to
Disneyland
to
come
across
to
DCA
and
generate
about
$
100
million
in
annual
a^er-‐cash
flows
for
the
firm.
¨ By
2008,
DCA
had
not
performed
up
to
expectaUons.
Of
the
15
million
people
who
came
to
Disneyland
in
2007,
only
6
million
visited
California
Adventure,
and
the
cash
flow
averaged
out
to
only
$
50
million
between
2001
and
2007.
¨ In
early
2008,
Disney
faced
three
choices:
¤ Shut
down
California
Adventure
and
try
to
recover
whatever
it
can
of
its
iniUal
investment.
It
is
esUmated
that
the
firm
recover
about
$
500
million
of
its
investment.
¤ ConUnue
with
the
status
quo,
recognizing
that
future
cash
flows
will
be
closer
to
the
actual
values
($
50
million)
than
the
original
projecUons.
¤ Invest
about
$
600
million
to
expand
and
modify
the
par,
with
the
intent
of
increasing
the
number
of
aOracUons
for
families
with
children,
is
expected
to
increase
the
percentage
of
Disneyland
visitors
who
come
to
DCA
from
40%
to
60%
and
increase
the
annual
a^er
tax
cash
flow
by
60%
(from
$
50
million
to
$
80
million)
at
the
park.
Aswath
Damodaran
318
DCA:
EvaluaUng
the
alternaUves…
319
¨ ConUnuing
OperaUon:
Assuming
the
current
a^er-‐tax
cash
flow
of
$
50
million
will
conUnue
in
perpetuity,
growing
at
the
inflaUon
rate
of
2%
and
discounUng
back
at
the
theme
park
cost
of
capital
in
2008
of
6.62%
yields
a
value
for
conUnuing
with
the
status
quo
Value
of
DCA
=
(Cost of capital - g) = (.0662 − .02) = $1.103 billion
Expected Cash Flow next year 50(1.02)
€
Aswath
Damodaran
319
First
Principles
320
The hurdle rate The return should How much How you choose
should reflect the The optimal The right kind
reflect the cash you can to return cash to
riskiness of the mix of debt of debt
magnitude and return the owners will
investment and and equity matches the
the timing of the depends upon depend on
the mix of debt maximizes firm tenor of your
cashflows as welll current & whether they
and equity used value assets
as all side effects. potential prefer dividends
to fund it. investment or buybacks
opportunities
Aswath
Damodaran
320